Earlier we provided two interpretations of a swap: (1) a package of futures/forward contracts, and (2) a package of cash market instruments. The swap spread is determined by the same factors that influence the spread over Treasuries on financial instruments (futures/forward contracts or cash) that produce a similar return or funding profile. As we explain subsequently, the key determinant of the swap spread for swaps with maturities of five years or less is the cost of hedging in the Eurodollar CD futures market. For longer maturity swaps, the key determinant of the swap spread is the credit spreads in the corporate bond market.

FundsGiven that a swap is a package of futures/forward contracts, the swap spread can be determined by looking for futures/forward contracts with the same risk/return profile. A Eurodollar CD futures contract is a swap where a fixed dollar payment (i.e., the futures price) is exchanged for three-month LIBOR. There are available Eurodollar CD futures contracts that have maturities every three months for five years. A market participant can synthesize a (synthetic) fixed-rate security or a fixed-rate funding vehicle of up to five years by taking a position in a strip of Eurodollar CD futures contracts (i.e., a position in every three-month Eurodollar CD up to the desired maturity date).

For example, consider a financial institution that has fixed-rate assets and floating- rate liabilities. Both the assets and liabilities have a maturity of three years. The interest rate on the liabilities resets every three months based on three-month LIBOR. This financial institution can hedge this mismatched asset/liability position by buying a three-year strip of Eurodollar CD futures contracts. By doing so, the financial institution is receiving LIBOR over the three-year period and paying a fixed dollar amount (i.e., the futures price). The financial institution is now hedged because the assets are fixed rate, and the strip of long Eurodollar CDs futures synthetically creates a fixed- rate funding arrangement. From the fixed dollar amount over the three years, an effective fixed interest rate that the financial institution pays can be calculated. Alternatively, the financial institution can synthetically create a fixed-rate funding arrangement by entering into a three-year swap in which it pays fixed and receives three-month LIBOR. The financial institution will use the vehicle that gives the lowest cost of hedging the mismatched position. This will drive the synthetic fixed rate in the swap market to that available by hedging in the Eurodollar CD futures market.

For swaps with maturities longer than five years, the spread is determined primarily by the credit spreads in the corporate bond market. Because a swap can be interpreted as a package of long and short positions in a fixed-rate bond and a floating- rate bond, it is the credit spreads in those two market sectors that will be the key determinant of the swap spread. Boundary conditions for swap spreads based on prices for fixed-rate and floating-rate corporate bonds can be determined.4 Several technical factors, such as the relative supply of fixed-rate and floating-rate corporate bonds and the cost to dealers of hedging their inventory position of swaps, influence where between the boundaries the actual swap spread will be.

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Primary Determinants of Swap Spreads