Swap spread framework

CFA Level III
#1
  1. Why has the swap spread framework become a popular valuation yardstick in Europe for credit securities?; AND 2. Why might US managers embrace the swap spread framework for the credit asset class?

Please answer this is simple intuitive language….i cant follow Curriculum answer!

#2

The presumption is that the swap spreads are less prone to government manipulation than, say, Treasury spreads.

In Europe, most credit securities are high-quality, and the swap spread gives a good indication of credit risk; it’s been used for 20 years or so. For comparability, US managers will have to use swap spreads; Treasury spreads don’t translate instantly into swap spreads.

#3

Thanks Magician…does that mean in US swap spreads are not that used???

#4

I’m not sure; I don’t deal with swaps in real life.

Perhaps someone who does can chime in.

#5

ooooooohhhh!.. Treasuries are not Rf (over multiple compounding periods).

Between 2 parties Swap spreads ONLY reflect the credit spread

As a risk manager I would love to use the same and I don’t care what goverments think!

I don’t want a EE, EPE,(sorry for using some FRM terms, but they are Expected Exposure and Expected Positive Exposure) without the Counterparty risk being managed and I just want the Swap Spread.

… Oh ! did I mention they are STABLE!!

#6

Thanks Abal –you seem rock solid on this topic. I have picked these points from Curriculum but could you lay this in baby language……just for me to grasp the logic!

My limited understanding of fixed income is: If a treasury note is quoted at 5% and global bond A is quoted at 6%, the nominal spread and swap spread for Bond A is 1% (compared with the Treasury note). I understand you cant use nominal spread if the bond is floating blur blur…but how do your points (listed above) make swap spread better applying to the example I have given above…in particular:

  1. how does “Treasuries are not Rf (over multiple compounding periods)” make the swap spread better?
  2. why “between 2 parties Swap spreads ONLY reflect the credit spread” – I would think nominal spreads also do that??
  3. “As a risk manager I would love to use the same and I don’t care what governments think!”—why would the spread not be affected by gvt yield if it is the difference between gvt yield and bond yield?
  4. Not sure what you mean with the EE, EPE –again applying to the above example what do you mean.
  5. Still dont understand why swap spread would be more STABLE if its just a difference between two rates??
#7

Anyone at home???

#8

Sorry Broadex for the delay. I do not get many concepts to which I post in the forum and except for our Magician I don’t get much help, and that to me is frustrating. I mean what this forum is for in the first place? Trust me, I also do not get lot of concepts and nobody answers, I can feel your sentiment

Anyway, I shall try explaining in the chronological manner you put forth :

  1. A SWAP is a private contract. It has nothing to do with the Treasuries or the LIBOR EXCEPT for the fact that betn. 2 parties the LIBOR or Treasury can be taken as the reference to which the SPREAD may be added. Your understaning of nominal spread of 1% in the example cited as the swap spread is not quite there.

If the same was true then there was no need to put a SWAP spread in the first place.

  1. Over multiple periods the Treasuries vary and hence the volatility violates the Treasury being Risk Free, however Swap Spreads are generally for 10, 20, 30 Years thus the spread once decided remains constant and is denoted by the SFR ( I am sure you would know this from L2). So if I have to take the reference rate I take Swap Spread that are avl. for all maturities. And the best part is it remains constant.

  2. Nominal spread need not necessarily reflect the default spread. There could be other elements as well e.g. Option, Maturity, Liquidity, Business Cycle, Modeliing Risk and et. all. Swap ONLY deals with default.

  3. Ignore the terminology.

  4. Because the Swap is a Pvt. contract ( executed by banks). Once entered into the contract I could not care what happens to Treasury yields. I am SPECIFICALLY talking about the SFR.

  5. sTABLE- Because it is fixed (unless the contracts calls in for a review)

Hope the above suffice.