An interest rate swap is an agreement in which one party, the fixed rate payer, exchanges periodic interest payments with another party, the floating rate payer, based on an agreed upon notional principal, maturity and predetermined fixed rate of interest or floating money market index.
Swaps are not risk-free securities and are characterised by credit risk as well as other risks. To compensate for these risks, market swap rates are generally at a premium over the comparable Treasury rates. This premium is the swap spread i.e. the swap spread is the difference between the swap rate and the Treasury bond rate of comparable maturity.
By way of illustration, if the going rate for a 10-year swap is 5 per cent and the 10-year government bond is yielding 4 per cent, the 10-year swap spread is 100bps.
Swap spreads correlate closely with credit spreads and reflect perceived risk that swap counterparties will fail to make their payments. Swap spreads are affected by the interest rate, credit risk and liquidity.