Swap Spread

What is Swap Spread?

A swap spread is the difference between the fixed rate on an interest rate swap (the swap rate) and the yield on a government bond of similar maturity. It reflects differences in credit risk, funding costs, and liquidity conditions between the swap market and the government bond market. Swaps are frequently quoted as the swap spread (another option is the swap rate).

Interpreting the Swap Spread

Swap spreads are considered important indicators of market conditions because they capture differences between the perceived safety of government bonds and the risks embedded in the swap market.

Positive swap spreads usually suggest that swaps are riskier than Treasuries, reflecting credit risk in the interbank market and liquidity preference for government bonds. Conversely, negative swap spreads can occur, particularly in longer maturities, often due to supply/demand imbalances in Treasuries, regulatory constraints on dealers, or funding market dynamics.

In this sense, swap spreads are used by economists and traders to gauge credit conditions, funding costs, and demand for safe assets, making them a valuable measure of overall market sentiment.

Practical Example

ABC Corp. enters into an interest rate swap agreement with XYZ Corp. It is a 3-year interest rate swap in which ABC Corp. (the payer) must pay a 3% fixed interest rate, while XYZ Corp. (the receiver) must pay a floating interest rate tied to 3-month SOFR (Secured Overnight Financing Rate), reset quarterly. The current 3-year yield on the default-free government bond is 1.5%.

To calculate the spread of the swap, determine its swap rate. According to the definition, the swap rate is the fixed rate of the swap. Thus, the swap rate of the swap contract between ABC Corp. and XYZ Corp. is 3%, which represents the swap’s fixed rate.

The swap spread is the difference between the swap rate and the yield on a government bond with a similar maturity. Therefore, the swap spread is calculated as:

Additional Resources

CFI is the official provider of the Capital Markets & Securities Analyst (CMSA®) certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources below:

• Market Risk Premium
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• 10-Year US Treasury Note
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