Bond crash/course: Swaps references

People stop me on the street all the time and say, “Hey there, Nemo. Where do you get all this stuff? Did you read a book or something?” And I say no, of course not, who reads books anymore? Besides, you do not have to read anything to state the obvious.

I read (or attempted to read) many on-line sources to put together my last four crash/course posts. These are the ones that I liked the best.

For a very accessible overview of swaps, swap rates, and why they matter, I recommend Swaps and the Swaps Yield Curve by Joseph Haubrich, a researcher at the Cleveland Fed. It was written in 2001, so the very first paragraph contains this gem:

Spreads between swap rates and Treasury bonds are becoming a closely watched indicator of the market’s view of macroeconomic risk. Furthermore, some analysts view swaps as the most likely replacement for Treasury bonds as a financial benchmark, should budget surpluses dry up the government bond market.

You see, what with all those surpluses in the federal budget, the Treasury will be retiring bonds instead of issuing them. This threatens to dry up the Treasury market and make Treasury yields useless as a benchmark!

Umm, yeah. I am thinking we will not have to worry about that again for a while… But seriously, it is a very good piece. Read it if you have time.

My primary source for the last two posts was Fundamental Securities in Fixed Income Derivatives, the notes from a lecture for a fixed income class at UChicago. This is a great introduction to all sorts of instruments, and it includes a section near the end on swap pricing.

The same lecturer also gives us Using a Bootstrap Procedure to Build a LIBOR Curve, providing a glimpse of the combination of science and art that goes into deriving a zero-coupon yield curve from a par bond yield curve (or swap rates). If you worked for a large bank and needed to set your swap pricing, this is the sort of thing you would need to know. I don’t, so I only skimmed this one.

I finally got my head around the derivation when I discovered Decomposing Swap Spreads, the slides for a seminar at Stanford. If you think my last few posts were dense, this guy covers the same ground in his first two slides.

These references generally start with the discount factor (also called the “price function”) P(t), where I decided to start with the zero-coupon yield curve y(t). They are related by P(t) = 1/(1+y(t))t, so it does not really matter where you start. But I prefer to think of the yield curve as given and everything else flowing from there.

Why bother going through this derivation at all? Because everything should be made as simple as possible, but no simpler. LIBOR swap rates are constantly quoted right next to Treasury yields; for instance, in the Fed’s daily H.15 statistical release. I wanted to understand why such a comparison makes any kind of sense. It is not at all obvious from the definitions of “swap” and “bond”.

That is all for this installment. (Hey, I need a break.)

Next time: The freaky NEGATIVE swap spread.

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