Synthetic Swap Spreads

Spreading Cash Treasuries and CBOT Interest Rate Swap Futures

CBOT 5-year and 10-year Interest Rate Swap futures provide a transparent, efficient, and cost-effective means to participate in the swap spread market. 

Since the late 1990s, the benchmark for pricing debt issuance has been the swap curve. Swap rates, like the London Interbank Overnight Rates (LIBOR), reflect the “riskless” rate of Treasury securities plus the credit risk associated with the financial sector. Swap yields are conventionally quoted as a “spread over Treasuries,” thus parsing out the credit component of the rate. Typical over-the-counter transactions involve dealers buying (selling) on-the-run Treasuries versus paying (receiving) the fixed rate of a DV01 equivalent par swap.

The OTC swap spread market has significant challenges:

  • A bid/ask spread and settlement that lacks optimal transparency
  • Administrative costs that can be burdensome
  • Counterparty credit risk as parties to an OTC swap assume the other’s credit risk

This limits participation in the swap spread market to highly capitalized dealers. By diminishing barriers to entry, CBOT Interest Rate Swap futures increase the pool of market participants eligible to trade swap spreads.

CBOT Swap Futures: A Clean Alternative

For those parties seeking relief from the hurdles of the OTC market, CBOT Interest Rate Swap futures provide a flexible, cost-effective way to manage swap rate exposure. 

Participants can synthetically create swap spread exposure by buying (selling) on-the-run Treasuries and selling (buying) the DV01 equivalent of CBOT Swap futures. The “off exchange” facilities available (Exchange for Physicals, Exchange for Swaps and Wholesale Trades) enable parties to negotiate a bilateral agreement, similar to the OTC market.

CBOT Interest Rate Swap futures:

  • Reduce the heavy administrative costs and legal documentation associated with trading plain vanilla swaps.
  • Virtually eliminate counterparty credit risk through the guarantee of the CBOT clearing services provider
  • Provide a transparent bid/ask spread and settlement
  • Enable all outstanding trade in Swap futures to be aggregated into a single position.

Synthetic Swap Spread Example

Assume the following market conditions:

10-year Swap spreads:  53 basis point (bps) mid-market
10-year cash Treasuries (4½% of Feb 2016): Price = 95-26+  Yield = 5.043
Forward start (IMM forward starting swap minus a spot dated swap):  1.29 bps

The underlying forward swap rate for CBOT 10-year Swap futures is calculated as follows:
Treasury yield  +   Swap spread   +   Forward start    =     Underlying Swap Yield
5.043              +        .53             +     .0129              =            5.5859

The Swap futures fair value is determined by inserting this yield into the valuation formula for 10-year Swap futures:
$100,000 * (6/r+(1-6/r) * (1+r/200)-20  =  Swap Futures Fair Value
$100,000 * (6/5.5859 + (1-6/5.5859) * (1+5.5859/200)-20       =    103-4+

In effect, this means that buying (selling) cash 10-year Treasuries at 95-26+ and selling (buying) 10-year Swap futures at 103-4+ is equivalent to being long (short) swap spreads at the mid-market swap spread of 53 bps.

This relationship can also be expressed as: 
Underlying Swap yield – Treasury yield – Forward Start   =   Spot Swap Spread

Quoting the Synthetic Swap Spread

Buying (selling) the synthetic swap spread means buying (selling) the cash Treasury leg of the spread and is equivalent to being long (short) swap spreads. There are two market conventions for quoting the synthetic swap spread.

  • Market Convention #1

Market participants quote the synthetic swap spread as the price at which they would buy or sell cash Treasuries against a pre-determined, or “pegged,” Swap futures price.

Thus, given a Swap futures price of 103-04.5, a liquidity provider would buy cash Treasuries at 95-26 or sell them at 95-27, against a DV01-equivalent counter-trade in CBOT 10-Year Swap futures.

  • Market Convention #2

Market participants quote the synthetic swap spread as a basis trade.  The basis is expressed as the Treasury price minus the Swap future price multiplied by a duration weighted conversion factor, which reduces the effects of duration differences.  The spread is then quoted in terms of the total number of 32nds of a price point, rounded to the nearest 1/8th of a 32nd.

By this measure, fair value in the synthetic swap spread (given a conversion factor of .97) would be:
Treasury price   – (Swap futures price x Conversion factor)
99-26+             – (103-4+ x .97)            = - 7/32nd
Hence, a liquidity provider might bid this DV01 neutral spread at -7+/32nds and offer it at