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Activity Handout

The Interest Swap Spread

Author

Diego Mendez-Carbajo, Department of Economics, Illinois Wesleyan University

dmendez@iwu.edu

Step-By-Step Activity Description

The user of the FRED database will take the following steps in order to quantify the concept of the interest swap spread.

(Step 1)

The user will first generate a graph of the 10-Year Swap Rate (MSWP10) (Category: Money, Banking & Finance > Interest Rates > Interest Rates Swaps)

(Step 2)

The user will then “Add a Data Series > Add New Series”, graphing the 10-Year Treasury’s Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)

(Step 3)

The user will then “Edit Data Series 2” (10-Year Treasury’s Constant Maturity Rate (WGS10YR)) by deleting it [click on trash can icon to the right of the series’ name].

Next, the user will “Add a Data Series > Modify Existing Series > Data Series 1”, graphing the 10-Year Treasury’s Constant Maturity Rate (WGS10YR) (Category: Money, Banking & Finance > Interest Rates > Treasury Constant Maturity)

These steps are needed in order to have both series as part of the same database object and allow for their manipulation. This manipulation is accomplished by selecting “Create Your Own Data Transformation > Formula > a – b > Apply”

The graph now plots the difference between the LIBOR-based interest swap rate and the risk-free maturity-matching asset, a computation of the interest swap spread.

Suggested Discussion Questions

• What do the positive values of the interest swap spread represent in terms of quantifying the risk of LIBOR-yielding deposits versus maturity-matching risk-free Treasuries? Why does the interest swap spread, up until 2009-2010, register positive values?

• How did the 2008-2009 financial crisis affect the 10-year interest swap spread? Should you revise your answer to the previous question? What are the implications of a negative value in the interest swap spread in April 2010 and August 2010?

Further Sophistications

• Plot the difference between the 1-Year Swap Rate (MSWP1), the 2-Year Swap Rate (MSWP2), the 5-Year Swap Rate (MSWP5), the 10-Year Swap Rate (MSWP10), and the 30-Year Swap Rate (MSWP30). Discuss the evolution of the term premium across interest swap rates of different maturities. Particular attention should be paid to the discussion of its evolution several years ahead of the 2008-2009 financial crisis.

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