What it is:
How it works (Example):
Companies engage in swaps in order to benefit from an exchange of comparative interest rate advantage. The terms of a plain vanilla (i.e. straightforward) swap are highly variable from contract to contract based on the needs of and resources available to the participating counterparties. A Treasury bond is often used as a benchmark because its rate is considered risk-free. The swap spread on a given contract indicates the associated level of risk. Risk increases as the spread widens. For instance, if one 10-year swap, XYZ, has a fixed rate of seven percent and a 10-year Treasury bond with the same maturity date has a fixed rate of five percent, the swap spread would be two percent (200 basis points) (7% - 5% = 2%).
Why it Matters:
As a reflection of risk, swap spreads are often used to assess the creditworthiness of participating parties.