What is a Swap Curve?
A swap curve is a line graph of the relationship between swap rates and time. It is much like the popular yield curve, which is a relationship between bonds and time. The swap curve is also used in the same way as the yield curve — it is a helpful tool when trying to compare prices between swaps at different time periods.
Swaps fall under the umbrella of derivatives. There are contingent claims, such as options, and forward claims, such as exchange-traded futures (ETFs). The former is contingent on the occurrence of an event while the latter is based on forward or future claims on cash flow. Swaps are a member of the latter group, forward claims.
In a nutshell, a swap is an agreement between two entities to swap cash flows for a specific period of time. The cash flows are generally determined by a fixed or variable interest rate or future commodity price. Unlike most derivatives, swaps are not traded over an exchange. They are customized specifically for the two parties involved. As such, there is no guarantee on the trade being upheld.
The primary users of swaps are companies and financial institutions. The most simplistic and common form is referred to as the interest rate swap. This is when one party agrees to pay another party a fixed rate of interest. The other party agrees to make payments based on variable interest rates over the same time period. Both sets of cash flow are in the same currency.
Common users of swaps include insurance companies and corporations. For example, when interest rates are falling, companies want to lock in a fixed rate, so they enter into an interest rate swap. The transaction allows the company to switch variable rate payments for fixed rate payments.
Since swaps are customized, the time periods can range from daily, weekly, monthly, quarterly or annually. Analysts draw the curve based on plotting swap prices at different time periods. The line will usually curve either up or down.
A downward swap curve is indicative of prices for long-term swaps trending down over time. An upward swap curve is indicative of prices for swaps trending up over time. The shortest time period is first. Specifically, the x-axis is used to plot the time period or life of the swap contract, and the y-axis is used to plot the price of the swap. By plotting at least three different time periods, the analyst can extrapolate or forecast where the line will trend over time.
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