Chapter 9
Trading Swap Spreads
Chapter 8 introduced the concept of hedging, whereby similar products can be traded in opposite directions to offset risks. As mentioned, hedging will not eliminate all risks in such transactions; instead, it leaves the investor with exposure to the difference in valuation of the product being hedged and the hedge instrument. Trading or hedging Treasury bonds versus swaps is so commonly done that it has a special designation: a swap spread trade. Whether viewed as a speculative trade or a hedge, a swap spread essentially takes a view on the difference in interest rates between the swap market and the Treasury bond market. Although a difference between two rates, the swap spread can be thought of as a separate trading entity of its own to express views. This chapter discusses the fundamental principles of the trade and the large variety of factors that may drive such trades. Swap spread trades allow investors to take views on a range of concepts, ranging from the path of federal budget deficit to mortgage market activity.
HOW SWAP SPREADS WORK
Before we begin on details, a clarification on market convention is needed. The difference between any two rates in fixed income is known as a spread, with spreads such as corporate spreads (corporate yield – swap yield) and mortgage spreads (mortgage yield – swap yield). As with corporates or mortgage-backed securities, one can look at Treasury spreads to swaps—that is, Treasury yield minus swap yield. Given ...
