Interest Rate Swaps: Valuation, Swap Spreads, and Asset Swaps

An interest-rate swap is the workhorse of the rate derivatives market. By exchanging a fixed-rate stream of cash flows for a floating-rate stream — or vice versa — it allows banks to transform the nature of their interest-rate exposure without transacting in the underlying bonds. A floating-rate borrower can synthetically convert to a fixed-rate payer by entering a swap; a fixed-rate bond investor can hedge duration by receiving floating in a swap. The par swap rate — the fixed rate that makes the swap worth zero at inception — is one of the most widely watched market indicators: it summarises the market's expectation of future short rates, the risk premium for term borrowing, and credit considerations for the counterparty. The swap spread (par swap rate minus Treasury yield) and the asset swap spread (yield spread between a bond and swaps) are the two most important relative-value metrics in fixed income.