Fixed Income Relative Value Analysis: A Practitioners Guide to the Theory, Tools, and Trades

Chapter 8

Theoretical Determinants of Swap Spreads

One of the fundamental relative value relations in the fixed income markets is that between government bond yields and the fixed interest rates of plain vanilla interest rate swaps. These swap spreads have been traded and studied extensively since the advent of the first interest rate swap in 1981, and in this chapter we discuss the theoretical determinants of swap spreads.

Old Approach: Looking at Default Risk of Swap Counterparties

Until the mid-1990s, most analysts and academics attributed the spread between swap rates and government bond yields to the credit risks of the two counterparties in the swap. In this framework, swap rates were like corporate bond yields, which are higher than government ...