Page 13 - FINAL CFA II SLIDES JUNE 2019 DAY 9

LOS 34.f: Explain the swap rate curve and why READING 34: THE TERM STRUCTURE AND
and how market participants use it in valuation. INTEREST RATE DYNAMICS
MODULE 34.3: THE SWAP RATE CURVE

The swap rate is the fixed rate paid by a counterparty in order to benefit the variable rate in a plain vanilla interest rate swap. A
Swap rates curve represents different swap rates for swap instruments with different maturities.

Rather than government bond yield curve (GBYC), it is the preferred interest-rate benchmark for credit markets, as:

• It reflects the credit risk of commercial banks rather governments;

• The swap market is not regulated by any government, allowing comparisons between countries (GBYC include sovereign risk);

• It has yield quotes at many maturities, while the U.S. GBYC has ‘on-the-run issues’ trading at few number of maturities.

Many banks that manage interest rate risk with swap contracts use swap curves to value their assets and liabilities, with the
LIBOR swap curve being the most common as it roughly reflects the default risk of a commercial bank.

CFA Level II is about valuation, so how do we value a SWAP?

Given a notional loan principal of $1, a swap fixed rate SFR , and swap tenor T, the value of the fixed rate payments can be
T
computed using the relevant (e.g., LIBOR) spot rate curve:

SFR can be thought of as the coupon rate of a $1 par value bond given the
underlying spot rate curve.