A swap curve is a linear graph showing the relationship between swap rates and time, used to compare prices between swaps at different time periods. Swaps are customized agreements between two entities to exchange cash flows for a specified period of time, commonly used by companies and financial institutions. The curve can indicate whether swap prices tend to rise or fall over time.
A swap curve is a linear graph of the relationship between swap rates and time. It’s a lot 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 useful 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 depends on the occurrence of an event, while the latter is based on future or future claims on cash flow. Swaps are members of the latter group, future claims.
Simply put, a swap is an agreement between two entities to exchange cash flows for a specified period of time. Cash flows are generally determined by a fixed or variable interest rate or a future commodity price. Unlike most derivatives, swaps are not traded on an exchange. They are customized specifically for the two parties involved. As such, there is no guarantee on the trade being held.
The main users of swaps are companies and financial institutions. The simplest and most common form is called an interest rate swap. This is when one party agrees to pay another a fixed interest rate. The other party agrees to make payments based on variable interest rates over the same period of time. Both sets of cash flows 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 exchange variable rate payments for fixed rate payments.
Since swaps are customized, the time periods can be daily, weekly, monthly, quarterly, or yearly. Analysts draw the curve based on the planning of exchange prices in different time periods. The line will usually curve up or down.
A falling swap curve is indicative that long-term swap prices tend to decline over time. A rising swap curve is indicative of swap prices that tend to rise over time. The shortest period of time is the first. Specifically, the x axis is used to plot the time period or life of the exchange contract, and the y axis is used to plot the exchange price. 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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