Part 3: Swap Markets and RV Trading
A Smarter Introduction to Swap Markets and Relative Value Trading
Interest rate swaps are one of the deepest and most liquid derivative markets globally. They give investors a highly flexible toolkit to hedge risk, bet on rate moves, or exploit relative value (RV) opportunities across the yield curve.
This article is the third installment of my primer series on interest rate markets. Previously, I covered:
Part 1: Understanding Yield Curve Risks and Trading Strategies
Part 2: Relative Value in Government Bonds
Now, we turn to swaps — practical, powerful, and a vital piece of the macro and RV toolkit.
What are Interest Rate Swaps?
At the core, a standard ("vanilla") interest rate swap is a contract where two parties exchange cash flows: one pays a fixed rate, the other pays a floating rate linked to an index like SOFR, Euribor, or BBSW. No principal is exchanged — only the interest payments.
Swaps can run from as little as a few months to over 30 years. Because there’s no principal changing hands, they're a highly capital-efficient way to express interest rate views without having to deal with bond issuance or repo funding headaches.
Common uses for swaps:
Hedging: Lock in borrowing costs or protect against falling asset yields.
Speculation: Bet on rising or falling interest rates by paying or receiving fixed.
Relative value trading: Exploit distortions between swap rates and bond yields, or anomalies within the swap curve itself.
Portfolio management: Adjust duration quickly without selling bonds.
Pricing and Risk Basics
A new swap is priced so that the present value (PV) of the fixed and floating legs match — in other words, the swap has a PV of zero at inception. But as market rates move, that balance changes, and the swap’s value fluctuates.
Importantly:
Notional amount ≠ risk exposure.
Risk depends more on the duration (interest rate sensitivity) than the face value.
For example, a 10-year swap with a $100 million notional has much more market risk than a 1-year swap of the same notional.
Also, swaps today are mostly centrally cleared through clearinghouses, and subject to daily margining — greatly reducing counterparty risk compared to pre-2008 practices.
Forward Swaps and Trading RV
One of the beautiful features of swaps is the flexibility to start them forward — meaning you lock in today’s rate but start exchanging cash flows at a future date.
Forward swaps are incredibly useful for:
Hedging future funding needs (e.g., locking in loan costs for a project starting next year).
Targeting specific curve points for relative value trades without messy funding issues.
For instance, if the 7-year point on the curve looks unusually "cheap" compared to the 5- and 10-year points, you could set up a 6y forward 1y swap (receiving fixed at 7y effective) to specifically trade that distortion.
Forward starting structures allow highly targeted RV trades that avoid the clutter and correlation of outright bond positions.
Carry and Rolldown in Swaps
Just like bonds, swaps have "carry" (the income you earn by holding the position) and "rolldown" (the change in mark-to-market value as time passes along a sloped curve).
Understanding carry and rolldown helps answer two key questions:
How much P&L can I expect if nothing changes?
What breakeven move in rates would wipe out my carry?
Spot swaps benefit from both carry and rolldown; forward swaps mainly roll down the curve. These dynamics can materially impact returns and need to be considered carefully, especially in volatile markets.
See my carry and roll post for a full breakdown.
Identifying RV Opportunities on Swap Curves
Swap curves generally tend to be smoother than government bond curves, but they’re not immune to distortions — especially around key macro themes, funding stresses, or positioning shifts.
Ways to spot opportunities:
Visual inspection: Look for kinks, bumps, or irregularities in the curve.
Forward rate analysis: Compare implied forward rates at different maturities.
Quantitative models: Fit a theoretical "fair value" curve and identify cheap or rich points.
Simple trades like curve butterflies (e.g., receiving 2y and 10y, paying 5y) can be used to capture mispricings, but they can be highly directional if not carefully structured. More sophisticated approaches (like risk-weighted "box" trades) aim to isolate pure RV without heavy macro exposure.
Beyond Vanilla: Basis Swaps
Not all swaps are fixed vs. floating. Basis swaps — where both legs float — open up additional RV themes.
Two major types:
Tenor basis swaps (e.g., 3M vs. 6M LIBOR or SOFR): Driven by liquidity premiums, credit spreads, and regulatory factors.
Cross-currency basis swaps (e.g., USD vs. EUR funding spreads): Reflect supply/demand for funding in different currencies.
These basis trades are often less correlated to outright rate moves, making them attractive diversifiers in a macro portfolio.
Final Thoughts
Interest rate swaps are at the heart of global financial markets, powering everything from speculative trades to massive hedging programs. Their flexibility and liquidity make them indispensable tools for both outright and relative value strategies.
If you want to navigate the yield curve more precisely — or express macro themes with better capital efficiency — mastering swaps is essential.