What does the Interest Rate Swap Yield Curve Imply?
What is a Yield Curve?
The yield curve shows the relationship between yield and the term to maturity, at any given point in time.
It provides important information on what the wholesale market’s expectations are on monetary policy, economic activity and inflation.
What is the Interest Rate Swap Yield Curve?
The interest rate swap yield is a collection of interest rates from the spot date; to 1, 2, 3, 4, 5 and 6 months; to 1, 2, 3, 4, 5, 7, 10 and 15 years. It is used to derive the zero coupon rates, which are then used to calculate the implied forward rates.
What is an Implied Forward Interest Rate?
An Implied Forward Interest Rate is the interest rate the Interest Rate Swap Yield Curve predicts will be the spot rate (today’s rate) at some point in the future.
An Example
If today’s 6 month interest rate is 5%, and the 3 month interest rate is 4%, then the 3 month implied forward rate is 5.94%.
Therefore, the market is implying that in 3 months time, the 3 month interest rate will be 5.94%. This means that an investor would be indifferent between –
(i) receiving 4% for 3 months and reinvesting at 5.94% for a further 3 months; or
(ii) receiving 5% for 6 months.
An Application
The implied forward rates are very important for anyone wishing to take a position on the direction of future interest rates movements. All speculative views (including to fix or to stay variable on your home loan) are only profitable when the interest rates that occur are different than those implied.
Therefore, when looking to establish a position (i.e., deciding to fix your home loan or stay variable), it is important to compare your view with the implied forward interest rates. If it is the same, there is no opportunity to profit from your view (i.e., you should be indifferent whether you should fix or not).