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SWAP CURVE

INTEREST RATE STRUCTURE

Let us consider zero-coupon bonds without default risk representing a variety of maturities. By plotting their respective yields on a graph, we obtain a series of points that represent the components of an interest-rate curve. The interest rate structure indicates the relationship between the interest rate and maturity of the bonds.

The form of the interest-rate curve, commonly referred to as the swap curve, can vary significantly. Long-term rates are normally higher than short-term ones. In such cases one would speak of a rising or upward-sloping curve, whereas the opposite case would be described as an inverted, declining or downward-sloping curve. These shapes as well as the fluctuations of the interest rate structure have a direct impact on a bond’s price.

Ex :
EUR, HUF and USD curves as at 7 July 2005

We will try to explain here why rates differ depending on maturity. Unfortunately, none of the three theories presented below manages to explain all the possible reasons; they are, however, an aid to investors who want to understand this aspect of bond investing.

HOW ARE BONDS TRADED?

The Market Segmentation Theory
The market segmentation theory is based on the fact that there are investors who prefer long-term yields (pension funds, insurance companies, etc.) while others prefer short-term yields (investment funds, banks, etc.). A maturity-based market segmentation results, and the rates for each maturity will depend on the existing supply and demand for each segment.

In its simplest form , this theory does not take into account expectations about rate evolution and assumes that each investor always prefers the security that matches his time horizon. However, in practice, each investor has a certain degree of flexibility and will agree to invest in a security whose maturity does not match his or her targets if the yield offered is high enough.

The Expectations Theory
The expectations theory is the oldest of the three theories. It holds that all rates are determined by market expectations with regard to future rates in the short term. This amounts to saying that placing one’s money for a period of two years should be equal to placing it during one year, then placing the sum received at the end of that year for another year.

The Liquidity Preference Theory
The liquidity preference approach holds that investors would rather invest over short-term horizons, in the belief that “a pound in the purse is worth two in the land”. Moreover, uncertainty regarding the debtor’s credit concerning their long-term bonds makes these instruments riskier than short-term securities. They should thus offer higher yields to attract investors.

This theory explains above all an upward-sloping curve. As it is also based on investors’ expectations regarding future rates, it can also explain downward-sloping curves. The liquidity premium would have the effect of mitigating the degressive nature of the structure.

The weakness of this theory lies in the fact that it regards the market as homogeneous whole, with investors showing preference for a certain time horizon. But it is more realistic to consider that investors do not all have the same time horizons. Consequently, investors with longer time horizons will refuse to pay a premium on securities with maturities equalling their target terms and demand a premium for holding securities with shorter maturities.

WHY USE SWAP RATES AS A BENCHMARK?

Until recently, the ‘riskless’ benchmark of a bond market was the government institution of the market’s prevailing currency. Now, although very few governments have experienced bankruptcy, there are huge differences in quality depending on the country. Moreover, government bond markets are also affected by the law of supply and demand. Consequently, swaps have become the new benchmark aimed at correcting this problem.

A swap is a contract between two banks that wish to trade their risks. In an interest rate swap, one of the banks has a fixed-rate risk and desires to trade it for a floating-rate one, and the other party has a floating-rate debt and wishes to trade it for a fixed-rate one.

The swap rate is the fixed rate used for this exchange of risks between high-quality banks. Consequently, it has become the benchmark standard for setting the non-risk rate.

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