The Swap Rate Curve

The Swap Rate Curve

In a plain vanilla interest rate swap, one party makes payments based on a fixed rate while the counterparty makes payments based on a floating rate. The fixed rate in an interest rate swap is called the swap fixed rate or swap rate.

If we consider how swap rates vary for various maturities, we get the swap rate curve, which has become an important interest rate benchmark for credit markets.

Market participants prefer the swap rate curve as a benchmark interest rate curve rather than a government bond yield curve for the following reasons:

Swap rates reflect the credit risk of commercial banks rather than the credit risk of governments.

The swap market is not regulated by any government, which makes swap rates in different countries more comparable. (Government bond yield curves additionally reflect sovereign risk unique to each country.) The swap curve typically has yield quotes at many maturities, while the U.S. government bond yield curve has on the run issues trading at only a small number of maturities.

Wholesale banks that manage interest rate risk with swap contracts are more likely to use swap curves to value their assets and liabilities. Retail banks, on the other hand, are more likely to use a government bond yield curve.

Given a notional principal of $1 and a swap fixed rate $SF{R}_T$, the value of the fixed rate payments on a swap can be computed using the relevant (e.g., MRR) spot rate curve. For a given swap tenor T, we can solve for SFR in the following equation.

In the equation, SFR can be thought of as the coupon rate of a $1 par value bond given the underlying spot rate curve.

To reflect this change, the CFA curriculum now uses the generic term MRR (“market reference rate”) to refer to these various LIBOR replacements.