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From: Oystein Sand
Affiliation: Student
Address: oysteisa@ulrik.uio.no
Date: 04 May 2000
Time: 07:11:06
As a partial answer to question 1: What factors affect swap spreads.
Consider a plain vanilla interest rate swap. The swap rate (the fixed rate) may be seen as the price for obtaining the floating rate payment. Hence the swap rate is the price which makes demand equal to supply in the plain vanilla market. Assuming a downward (upward) sloping demand curve (supply curve), an increase in demand for floating payments would raise the swap rate. An increase in supply of floating payments would lower the rate. From here on one should use ones imagination to figure out what may cause the swap rate to alter. For instance: in an environment of unusually high interest rates, economic agents may expect interest rates to decline, wanting to pay a floating rates instead of a fixed. The supply of floating payments would rise and the swap rate would fall, ceteris paribus.
The swap spread is defined as the difference between the swap rate and yield of ("on-the-run") government bonds of equal maturity (default-free bonds). Because many of the same factors may affect both the yield of government bonds and the swap rate, it is tricky to make precise assumptions about what causes the swap spread to alter. One factor, though, is too important not to be mentioned here: If the observed swap rate is quoted towards an AA entity, the swap spread should have the interpretation of a quality spread; the default premium risky agents need to pay above the default-free rate. Therefore, factors which affect the default premium in the market for non-government bonds should also affect the swap spread.
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