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What are swap curves?
Swap curve is the relationship between swap rates and varying maturities. This curve tells about the expected returns at different maturity dates. It is a two dimensional curve in which, Y-axis represents the swap rates and X-axis represents maturity dates.
These curves are calibrated and constructed in segments depends on market prices of different fixed income. The short end (not more than 3 months) swap curve is calibrated to unsecured deposit rates. Middle end (in between 3 months to 2 years) is derived in combination of interest rate futures and forward rate agreement contracts.
Long term (more than or equal to 10 years) are constructed using swap rates of observed quotes. Bootstrapping and interpolation techniques are used by markets which participate to join the curve segments for consistent and smooth functioning.
The benefits of using a swap curve are as follows −
- Prices of fixed income of mortgage securities, corporate bonds etc. are determined.
- Prices of cash flows, FX forwards etc. are stated.
- Potential trading opportunities are determined.
- Market perceptions are analysed.
- Performs sensitivity analysis, risk management, valuations etc.
Using swap curves
These curves help in identification different characteristics of swap rates with time. Maturity dates (time) is plotted on x-axis and swap rates are plotted on Y-axis. So the curves changes with time and rates. Swap curve changes for 1 month LIBOR, 3 month LIBOR etc. will have different rates. In simple words investor can see their possible returns for their swaps on different maturity dates using swap curves. Sensitivity to interest rates changes with time. The longer the maturity time the greater the sensitivity if interest rate. The swap curve is typically upward sloping because the longer term swap rates are higher than short term swap rates
In financial markets, swap curve is used as benchmark in establishing the fund rate (used to price fixed income products like corporates bonds and MBS (Mortgage-backed Securities). OTC (Over the counter) derivatives like forex swaps and nonvanilla swaps are price based. Aggregate market perception in fixed income market can also be gauged using swap curves
- Borrowings at lower cost
- New financial markets can be accessed
- Hedging to risk
- Mismatch of asset – liability can be managed
- Act as additional income
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