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A swap spread represents the difference in interest rates between a fixed-rate investment and an interest-rate swap. An interest rate swap is a derivative investment, in which one investor trades a series of interest payments for the other investor’s series of cash flows. Usually, one of the series of payments has a fixed interest rate and the other has a variable interest rate. In some interest rate swaps, both investments have a variable interest rate. Swapping two fixed interest rate investments wouldn’t make sense because the cash flows can be predicted.
The swap spread is the additional amount an investor would earn on an interest-rate swap as compared to a fixed rate investment. If the fixed rate investment pays 5.5 percent and the interest rate swap pays 5.9 percent, the amount of the swap spread is 0.4 percent or 40 basis points. There are 100 basis points in one percentage point.
In order to determine if an interest rate swap makes sense for both parties, investors look at the Quality Spread Differential (QSD), a calculation that takes into account the creditworthiness of the two parties in the transaction. Suppose Company A can borrow at a fixed rate of 3 percent or a floating rate of LIBOR, the London Interbank Offered Rate, which is commonly used for overnight loans between banks. Company B, which has a better credit rating than Company A, can borrow at a fixed rate of 2.5 percent or a floating rate of LIBOR minus 0.25 percent. The fixed rate differential between the two companies is 0.5 percent, and the floating rate differential is 0.25 percent. The difference between these two rates is the QSD, which in this case is 0.25 percent. Because it is positive, the transaction is beneficial to both companies.
Sometimes the two investments involved in an interest rate swap are denominated in different currencies. In some cases, one country will have relatively lower fixed interest rates while the other has relatively lower floating interest rates. This can affect the swap spread, and can be a factor in assessing whether the interest rate swap is advantageous for both parties.
The counterparty in an interest rate swap may be a swap dealer, who is compensated for his services by the swap spread. In other words, the difference in interest rates between the fixed rate investment and the interest rate swap makes up the swap dealer’s compensation. Because swap spreads are based on other underlying investments, they are considered derivatives.