SPREADLOCK
DESCRIPTION
A Spreadlock allows the Interest Rate Swap user to lock in the forward differential between the Interest Rate Swap rate and the underlying Government Bond Yield (usually of the same or similar tenor). The Spreadlock is not an option, so the buyer is obliged to enter the swap at the maturity of the Spreadlock. It can of course be reversed at any time up to and including maturity at the then market level.
In many markets (particularly in the USA), the rate quoted on an Interest Rate Swap is determined with reference to a government bond yield of the same or similar maturity, and may in fact be quoted as a spread over the government bond yield (in limited cases, the spread may be negative). The Interest Rate Swap fixed rate can therefore be thought of in two parts, the bond rate (usually referred to as T) plus the spread. An Interest Rate Swap seeks to lock in the combined rate, while a Spreadlock seeks only to lock in the spread portion of the rate and lets the underlying bond yield float. The Spreadlock allows the user to manage their interest rate exposure in the two underlying components of the swap rate and therefore provides potential flexibility. In almost all cases, the "spread" is the smallest component in the swap rate by far. A history of Swap spreads can be found in the Citibank annual publication "Interest Rate and Swap Spreads".
EXAMPLE
The current 5yr swap rate is 8% while the 5yr benchmark government bond rate is 7.70%, so the current spread is 30bp an historically low level. A company is looking to pay fixed using an Interest Rate Swap at some point in the year. The company believes however, that the bond rate will continue to fall over the next 6 months. They have therefore decided not to do anything in the short term and look to pay fixed later. It is now six months later and as they predicted, rates did fall. The current 5 yr bond rate is now 7.40% so the company asks for a 5 yr swap rate and is surprised to learn that the swap rate is 7.90%. While the bond rate fell 30bp, the swap rate only fell 10bp. Why? The swap spread is largely determined by demand to pay or receive fixed rate. As more parties wish to pay fixed rate, the "price" increases, and therefore the spread over bond rates increases. In this example, it would appear that as the bond rate fell, more and more companies elected to pay fixed, driving the swap spread from 30bp to 50bp. So while the company has saved 10bp, it could have used a Spreadlock to do better.
When the swap rate was 8% and the bond yield 7.70%, the company could have asked for a six month Spreadlock on the 5yr Swap spread. While the spot spread was 30bp, the 6mth forward Spread was say 35bp (see Pricing for explanation). The company could "buy" the Spreadlock for six months at 35bp. At the end of the six months, they can then enter a swap at the then 5yr bond yield plus 35bp, in this example a total of 7.75%. The Spreadlock therefore increases the saving from 10bp to 25bp.
PRICING
The Spreadlock "price" equals the difference between the implied forward swap rate and the implied forward bond yield (see Implied Forwards for calculation details). The swap spread "curve" can be thought of in isolation of the overall swap yield curve. As with all implied forwards, a positively sloped spread curve (i.e. swap spreads for shorter maturities are lower than longer maturities) implies that swap spreads will rise over time, and a negatively sloped spread curve (i.e. swap spreads for shorter maturities are higher than longer maturities) implies that swap spreads will fall over time.
TARGET MARKET
Spreadlocks are potentially useful for anyone considering the use of an Interest Rate Swap in the future. They are not available in all markets.
ADVANTAGES
Allows more precise interest rate management
Flexibility
Customised
DISADVANTAGES
Requires ISDA documentation
Implied forwards can sometimes be unattractive
Unlimited loss potential
PRODUCT SUITABILITY
Simple Defensive