Fixed income

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haiderraza

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the size of the government bond market relative to GDP is 214.3% for Japan
What does this statement mean?
 
How the swap curve can be used in fixed-income valuation?
 
Consider the case of a bank raising funds using a certificate of deposit (CD). Assume the bank can borrow $10 million in the form of a CD that bears interest of 1.5% for a two-year term. Another $10 million CD offers 1.70% for a three-year term. The bank can arrange two swaps: (1) The bank receives 1.50% fixed and pays three-month Libor minus 10 bps with a two-year term and $10 million notional, and (2) the bank receives 1.70% fixed and pays three-month Libor minus 15 bps with a three-year term and a notional amount of $10 million. After issuing the two CDs and committing to the two swaps, the bank has raised $20 million with an annual funding cost for the first two years of three-month Libor minus 12.5 bps applied to the total notional amount of $20 million. The fixed interest payments received from the counterparty to the swap are paid to the CD investors; in effect, fixed-rate liabilities have been converted to floating-rate liabilities. The margins on the floating rates become the standard by which value is measured in assessing the total funding cost for the bank.
I just need clarification on the last point please. what does this mean in reference to the above example?
 
To illustrate the use of the swap spread in fixed-income pricing, consider a US$1 million investment in GE Capital (GECC) notes with a coupon rate of 1 5/8% (1.625%) that matures on 2 July 2015. Coupons are paid semiannually. The evaluation date is 12 July 2012, so the remaining maturity is 2.97 years [= 2 + (350/360)]. The swap rates for two-year and three-year maturities are 0.525% and 0.588%, respectively. By simple interpolation between these two swap rates, the swap rate for 2.97 years is 0.586% [= 0.525% + (350/360)(0.588% – 0.525%)]. If the swap spread for the same maturity is 0.918%, then the yield to maturity on the bond is 1.504% (= 0.918% + 0.586%).
  • How is yield to maturity is calculated in this scenario? (last line)
  • Swap rate is the fixed interest rate that the fixed rate payer will have to pay in exchange of receiving a floating rate. What does the swap spread mean here and what is its role in this scenario?
 
The swap rate is a proxy for interest rate. It tells you that the bond has a positive spread of 0.918%.
After extrapolating the swap rate for the same maturity as the bond, you add the spread to get the YTM.
 
YTM is the total expected return by holding a security to maturity. How does this concept fit in this phrase. How does swap rate and swap spread add up to make YTM?
 
the swap rate is also the YTM for the same maturity period. You just add the spread of the bond above the swap.
 
A person who has entered into a swap agreement in which he will pay fixed and receive floating interest. The YTM for that person should be the floating rate, isnt it? Then how does the swap rate + spread concept comes in here?
 
For a swap think about what the person is getting right now, and what the interest rate environment is.
E.g. You are receiving Fixed. Interest rates are rising.
You would prefer to receive Floating - when Interest rates rise.
How do you do that? Draw a diagram. (cannot do it here - but this is for you)
You receive fixed -> give it up. So Pay Fixed and Receive Floating (SWAP).
When you receive Floating -> Swap Rate is received.
And any difference between (Pay Fixed on Swap - Receive Fixed on your Bond) = Spread is also received by you.
So net effect -> Swap Rate + Spread is received by you.
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Do the same from a Receive Floating perspective. In this case if interest rates are dropping you want to enter into a SWAP. – Exercise for you Again.
 
(i) I had an understanding that only fixed rate is called swap rate. So, by your statements I assume that which ever rate one is receiving, that is the swap rate. Correct?
(ii) your point in which you mentioned that (Pay Fixed on Swap - Receive Fixed on your Bond). Please elaborate this a bit for me.
 
haiderraza wrote:
(i) I had an understanding that only fixed rate is called swap rate. So, by your statements I assume that which ever rate one is receiving, that is the swap rate. Correct?
(ii) your point in which you mentioned that (Pay Fixed on Swap - Receive Fixed on your Bond). Please elaborate this a bit for me.
Click to expand...
1) The fixed rate on the swap is an interest rate that you can use to proxy a spread on the bonds. Does this make sense?
2) That’s the definition of a swap spread, it’s the difference between a bond yield and the swap rate. For example, if the fixed-rate of a 5-year fixed-for-float LIBOR swap is 7.26% and the 5-year Treasury is yielding at 6.43%, the swap spread is 7.26% - 6.43% = 83 bps. Likewise, you could find the spread between the swap rate and a corporate bond yield, or add the spread given to you between swaps and C-bonds to get the YTM on the bond.
 
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