Swap spreads as proxy for credit spreads

CFA Level III Fixed Income
#1

CFAI Reading 22 EOC q13.

Could someone please explain why and how swap spreads can be a good proxy for credit spreads? What swaps are they talking about?

Thank you,

#2

Swaps offered by banks.

Banks have credit risk; Treasuries haven’t. So the swap rates offered by banks include a credit risk premium; the difference between the swap rate and the Treasury rate of the same maturity is the credit spread for that maturity.

#3

Thank you Magician.

I was confused why it was just a proxy for and not equal to credit spreads. Your comment indicates that the difference in BankSwap and TresSwap equals BankCredit spread on risk free rate. Did I get it right?

#4

It’s not the difference between a treasury swap (not sure if that exists) it’s the difference between the rate on the swap and the rate on a treasury with the same maturity.

Think of it as a spread over the risk-free rate that compensates the trader for the risk of the counterparty failing to pay - which doesn’t apply in theory to the risk-free rate.