Handbook of Finance: Financial Markets and Instruments

Chapter 46. The Determinants of the Swap Spread and Understanding the LIBOR Term Premium

MOORAD CHOUDHRY, PhD

Head of Treasury, KBC Financial Products, London

Abstract: The use of interest rate swaps to manage and hedge interest rate risk exposure is widespread. The rate payable on a swap is a positive spread above the sovereign benchmark rate, reflecting interbank quality credit risk. The magnitude of this spread is dependent on various factors, including prevailing macro-level political and economic circumstances, supply and demand, the shape and level of the yield curve, and market volatility. Market practitioners analyze these factors and anticipate changes in the spread, as the extent of the spread feeds into hedge costs. Funding and hedging costs also reflect overall term premium rates. The level of the term premium in the short-term yield curve is a function of the current shape of the curve and market expectations of interest rate levels in the future.

Keywords: futures curve, interest rate swap, LIBOR curves, LIBOR spread, swap spread, term premium

An important hedging tool in bank asset-liability management (ALM) operations is the interest rate swap, a derivative instrument. In this chapter, we consider an important issue for interest rate analysis, the swap spread. Specifically, we look at the spread of the swap curve over the government bond yield curve; this subject is important because the swap spread is an indicator of value and risk premium in the market, as well as ...