What Is a Swap Curve?
The swap curve is a graph of fixed coupon rates of market-quoted interest rate swaps across different maturities in time. A vanilla interest rate swap consists of a fixed leg and a floating leg. At contract initiation, the fixed rate equates the cash flows from the fixed and floating legs over the contract’s maturity, resulting in a net cash flow of zero. By capturing market perceptions of the credit quality of the banking sector, swap curves enable you to visualize forward expectations of unsecured interbank lending rates such as LIBOR or Euribor.
Swap curves are typically constructed and calibrated in segments to the market prices of various fixed-income instruments. The short end of the swap curve (less than 3 months) is calibrated to unsecured deposit rates. The middle area of the curve (from 3 months up to 2 years) is derived from a combination of forward rate agreement contracts (FRAs) and interest rate futures (e.g., Eurodollar futures). The long end of the curve is constructed from observed quotes of swap rates (out to 10 years or more). Market participants use a combination of bootstrapping and interpolation techniques to join the segments of the curve together into a smooth and consistent whole.
Swap curves are used to:
- Price fixed-income instruments such as corporate bonds, mortgage securities, and other securitized products
- Price cash flows, nonvanilla swaps, FX forwards, and other OTC derivatives
- Determine potential trading opportunities by identifying normative gaps in market prices of financial instruments
- Analyze market perceptions of fixed-income market conditions in aggregate
- Perform valuation, sensitivity analysis, and risk management of fixed-income portfolios
Examples and How To
Risk Management with MATLAB
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