What is the least appropriate measure to identify and manage 'shaping risk' in a bond portfolio?
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The least appropriate measure for identifying and managing shaping risk is average maturity, as it does not provide specific insights into how the portfolio reacts to changes in the yield curve's shape compared to effective duration or key rate durations.
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What is a swap rate in the context of interest rate swaps?
A swap rate is the fixed rate in a plain vanilla interest rate swap, where one party pays a fixed rate and the counterparty pays a floating rate. The swap rate is used to determine the fixed payments in the swap agreement.
What is the swap rate curve?
The swap rate curve is a graph showing swap rates for various maturities. It serves as an important interest-rate benchmark for credit markets.
Why do market participants prefer the swap rate curve over the government bond yield curve as a benchmark?
Market participants prefer the swap rate curve because: (1) swap rates reflect the credit risk of commercial banks rather than governments, (2) the swap market is not regulated by any government, making rates more comparable across countries, and (3) the swap curve typically has yield quotes at many maturities.
How is the value of fixed rate payments on a swap computed?
The value of fixed rate payments on a swap is computed using the relevant spot rate curve. For a given swap tenor T, the swap fixed rate (SFR) is solved in the equation: sum from i=1 to T of SFR/(1+Si)^i + 1/(1+ST)^T = 1.
What is the relationship between the swap fixed rate and the coupon rate of a bond?
The swap fixed rate (SFR) can be thought of as the coupon rate of a $1 par value bond given the underlying spot rate curve.
How do you compute the swap fixed rate for a given tenor using spot rates?
To compute the swap fixed rate for a given tenor, set up the equation: sum of SFR/(1+Si)^i for each period plus 1/(1+ST)^T equals 1, and solve for SFR using the spot rates for each maturity.
What is the swap spread?
The swap spread is the amount by which the swap rate exceeds the yield of a government bond with the same maturity. Swap spread = swap rate – Treasury yield.
Why are swap spreads almost always positive?
Swap spreads are almost always positive because government bonds have lower credit risk compared to the surveyed banks that determine the swap rate.
What does a higher swap spread indicate?
A higher swap spread indicates higher compensation for liquidity and credit risk.
How is the swap spread used by investors?
Investors use the swap spread to separate the time value portion of a bond's yield from the risk premiums for credit and liquidity risk.
What does the swap spread provide for a default-free bond?
For a default-free bond, the swap spread provides an indication of the bond's liquidity and/or possible mispricing.
How is the swap spread calculated? Provide an example.
Swap spread = swap rate – Treasury yield. For example, if the two-year swap rate is 2.02% and the two-year U.S. Treasury yield is 1.61%, the swap spread is 2.02% – 1.61% = 0.41% or 41 basis points.
What is the I-spread and how does it relate to the swap rate?
The I-spread (interpolated spread) is the amount by which the yield on a credit-risky bond exceeds the swap rate for the same maturity.
How can missing swap rates for specific maturities be estimated?
Missing swap rates for specific maturities can be estimated from the swap rate curve using linear interpolation.
What is the significance of the swap rate curve in the valuation of assets and liabilities by banks?
Wholesale banks managing interest rate risk with swap contracts are more likely to use swap curves to value their assets and liabilities, while retail banks are more likely to use a government bond yield curve.
