Swap spreads reveal arbitrage opportunity between swaps and equivalent bond positions

Evidence

The “swap spread” is the difference between the fixed interest rate at which swaps can be entered into and the yield of a government bond with a similar maturity denominated in the same currency. Swap spreads can indicate arbitrage opportunities because the party to a swap who is paying a floating rate of interest while receiving a fixed rate is in a situation similar to that of someone who has borrowed money at a floating rate and used it to buy a bond that pays fixed interest. If there is enough of a discrepancy between the terms on which swap contracts can be entered into and on which positions in bonds in the same currency and of similar maturities can be financed, arbitrage may be possible. — Donald MacKenzie, An Engine, Not a Camera, 980

Categorization

• DEFINE: Defines the swap spread and the structural equivalence that makes swap-bond arbitrage possible — foundational mechanics for the whole LTCM swap-spread chapter.
• XREF: connects to: Credit default swaps escaped insurance reserve requirements by being misnamed swaps — Mark Blyth, Austerity: The History of a Dangerous…, 707; Swap spreads mean-revert, letting traders bet on widening to profit. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1301; Buying bonds and paying fixed in a swap nets a small positive cash flow. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1299