The Interest Swap Spread
This material was originally created for
Starting Point: Teaching Economics
and is replicated here as part of the SERC Pedagogic Service.
and is replicated here as part of the SERC Pedagogic Service.
Initial Publication Date: July 1, 2014
Summary
This case quantifies the interest rate swap spread, as reflected on the 10-year Treasury bond yields, over time. This activity can be used as either (a) an instructor-led example in which the instructor shows –either on paper or a screen– the data and students analyze them, or (b) as a student exploration in which students find the specified data. Instructors with less time could use option (a) and instructors interested in their students learning about the FRED database could use option (b).
This activity plots the interest rate paid by the fixed-rate payer on an interest rate swap transaction (e.g. the 10-Year Swap Rate), the yield on the matching Treasury bond (e.g. the 10-Year Treasury Constant Maturity Rate), and computes the difference between the two of them. This difference is an approximation of the swap rate and it displays both a secular trend and cyclical behavior.
This activity is suitable for addressing each of the following issues:1. How does the interest rate swap rate change over time?2. How did the interest rate swap spread adjust during the 2008-2009 financial crisis?3. What is the relationship between monetary policy and the interest rate swap spread?
This activity plots the interest rate paid by the fixed-rate payer on an interest rate swap transaction (e.g. the 10-Year Swap Rate), the yield on the matching Treasury bond (e.g. the 10-Year Treasury Constant Maturity Rate), and computes the difference between the two of them. This difference is an approximation of the swap rate and it displays both a secular trend and cyclical behavior.
This activity is suitable for addressing each of the following issues:1. How does the interest rate swap rate change over time?2. How did the interest rate swap spread adjust during the 2008-2009 financial crisis?3. What is the relationship between monetary policy and the interest rate swap spread?
Learning Goals
After the completion of this module students will be able to:
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how the interest rate swap spread changes in value over time.
4. Assess the impact of the 2008-2009 financial crisis on financial markets.
1. Use FRED graphs to perform data manipulations.
2. Use FRED graphs to perform a visual data comparison
3. Assess how the interest rate swap spread changes in value over time.
4. Assess the impact of the 2008-2009 financial crisis on financial markets.
Context for Use
Ideally this module should be directed to a financial economics class. It can be used as either (a) an instructor-led example in a large lecture or (b) student groups can be assigned to replicate it outside of class as a basis for a short assignment. Between the presentation of the data and the ensuing discussion, instructors should allocate 20-30 minutes of classroom time. The discussion could focus on the difference in risk between fixed and flexible interest rates and on why the interest rate swap spread became negative in early 2010.
Note that a more advanced treatment of this topic may compare swap rates of different maturities (e.g. 1-Year, 2-Year, 5-Year...) and discuss the evolution of their term premiums before, during, and after the 2008-2009 financial crisis. These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct.
Prerequisite skills: Graph literacy
Prerequisite concepts: Financial derivatives; Interest rate swaps; Interest rate swap spread
Note that a more advanced treatment of this topic may compare swap rates of different maturities (e.g. 1-Year, 2-Year, 5-Year...) and discuss the evolution of their term premiums before, during, and after the 2008-2009 financial crisis. These exercises may be used to illustrate how the choices made regarding data can either support or undermine a theoretical construct.
Prerequisite skills: Graph literacy
Prerequisite concepts: Financial derivatives; Interest rate swaps; Interest rate swap spread
Description and Teaching Materials
The following is a description of this activity being used as an instructor-led example. For a basic step-by-step description of this activity –also suitable for a student-led exploration of the topic– please see the Handout Activity Handout for the Interest Swap Spread (Microsoft Word 26kB Jun27 14).
(Step 1)
The instructor will first present a graph of the 10-Year Swap Rate (MSWP10) (Category: Money, Banking & Finance > Interest Rates > Interest Rates Swaps)
The instructor should point out that for the available data range the trend value of the Interest Swap Rate has been declining and that the series is generally procyclical. Special attention should be paid to the evolution of the series after the 2008-2009 recession relative to the evolution of the series after the 2000-2001 recession. This fact will become relevant when introducing an additional data series.
The instructor can ask students to review the relationship between interest rates and risk of default, discussing potential reasons for why the interest swap rate dramatically decreased in 2009 and between 2011-2013. The instructor can also ask students to review the relationship between bond yield and bond price. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.
(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the 10-Year Treasury's Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
The instructor should point out the effective co-movement between the series, with Treasuries offering –generally– lower yields than LIBOR-yielding deposits. The instructor can ask students to put forward an argument for why that is the case. Thus having introduced the concept of interest swap spread, discussion should turn to the extraordinary convergence in yield values after 2009.
(Step 3)
The instructor will then "Edit Data Series 2" (10-Year Treasury's Constant Maturity Rate (WGS10YR)) by deleting it [click on trash can icon to the right of the series' name].
Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing the 10-Year Treasury's Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > a – b > Apply"
The graph now plots the difference between the LIBOR-based interest swap rate and the risk-free maturity-matching asset, a computation of the interest swap spread.
The following is a list of questions that could be asked:
- What do the positive values of the interest swap spread represent in terms of quantifying the risk of LIBOR-yielding deposits versus maturity-matching risk-free Treasuries? Why does the interest swap spread, up until 2009-2010, register positive values?
- How did the 2008-2009 financial crisis affect the 10-year interest swap spread? Should you revise your answer to the previous question? What are the implications of a negative value in the interest swap spread in April 2010 and August 2010?
Further sophistication:
- Plot the difference between the 1-Year Swap Rate (MSWP1), the 2-Year Swap Rate (MSWP2), the 5-Year Swap Rate (MSWP5), the 10-Year Swap Rate (MSWP10), and the 30-Year Swap Rate (MSWP30). Discuss the evolution of the term premium across interest swap rates of different maturities. Particular attention should be paid to the discussion of its evolution several years ahead of the 2008-2009 financial crisis.
Within a lecture discussing financial derivatives, an instructor will use this module to help students understand the concept of the interest rate swap spread and to guide a discussion of its quantification.
(Step 1)
The instructor will first present a graph of the 10-Year Swap Rate (MSWP10) (Category: Money, Banking & Finance > Interest Rates > Interest Rates Swaps)
The instructor should point out that for the available data range the trend value of the Interest Swap Rate has been declining and that the series is generally procyclical. Special attention should be paid to the evolution of the series after the 2008-2009 recession relative to the evolution of the series after the 2000-2001 recession. This fact will become relevant when introducing an additional data series.
The instructor can ask students to review the relationship between interest rates and risk of default, discussing potential reasons for why the interest swap rate dramatically decreased in 2009 and between 2011-2013. The instructor can also ask students to review the relationship between bond yield and bond price. Questions of volatility can also be brought up by pointing out sudden and large changes in the value of the series.
(Step 2)
The instructor will then "Add a Data Series > Add New Series", graphing the 10-Year Treasury's Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
The instructor should point out the effective co-movement between the series, with Treasuries offering –generally– lower yields than LIBOR-yielding deposits. The instructor can ask students to put forward an argument for why that is the case. Thus having introduced the concept of interest swap spread, discussion should turn to the extraordinary convergence in yield values after 2009.
(Step 3)
The instructor will then "Edit Data Series 2" (10-Year Treasury's Constant Maturity Rate (WGS10YR)) by deleting it [click on trash can icon to the right of the series' name].
Next, the instructor will "Add a Data Series > Modify Existing Series > Data Series 1", graphing the 10-Year Treasury's Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)
These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting "Create Your Own Data Transformation > Formula > a – b > Apply"
The graph now plots the difference between the LIBOR-based interest swap rate and the risk-free maturity-matching asset, a computation of the interest swap spread.
The following is a list of questions that could be asked:
- What do the positive values of the interest swap spread represent in terms of quantifying the risk of LIBOR-yielding deposits versus maturity-matching risk-free Treasuries? Why does the interest swap spread, up until 2009-2010, register positive values?
- How did the 2008-2009 financial crisis affect the 10-year interest swap spread? Should you revise your answer to the previous question? What are the implications of a negative value in the interest swap spread in April 2010 and August 2010?
Further sophistication:
- Plot the difference between the 1-Year Swap Rate (MSWP1), the 2-Year Swap Rate (MSWP2), the 5-Year Swap Rate (MSWP5), the 10-Year Swap Rate (MSWP10), and the 30-Year Swap Rate (MSWP30). Discuss the evolution of the term premium across interest swap rates of different maturities. Particular attention should be paid to the discussion of its evolution several years ahead of the 2008-2009 financial crisis.
Teaching Notes and Tips
The popular press abounds in discussions of financial derivatives. These can be used to provide more poignant context. An example is "Swap rate falls below 10-year Treasury yield" (see full reference under Resources).
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Assessment
The recommended method for assessment for a financial economics class would be to have students write up a short memo where they discuss the historical evolution of the interest rate swap spread before, during, and after the 2008-2009 financial crisis. This should be a take-home assignment.
References and Resources
"Swap rate falls below 10-year Treasury yield" by Michael Mackenzie
Financial Times (ft.com), March 23, 2010
http://www.ft.com/intl/cms/s/0/4b2a9cda-36b0-11df-b810-00144feabdc0.html#axzz318uq0iho
Financial Times (ft.com), March 23, 2010
http://www.ft.com/intl/cms/s/0/4b2a9cda-36b0-11df-b810-00144feabdc0.html#axzz318uq0iho