Intermarket Spread Swaps - Explained
What is an Intermarket Spread Swap?
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Table of ContentsWhat is an Intermarket Spread Swap?How Does an Intermarket Spread Swap Work?Example of how an Intermarket Spread Swap WorksWays of Executing Intermarket Spread SwapUses of an Intermarket Spread SwapsRisks Associated with Intermarket Spread SwapsSummary
What is an Intermarket Spread Swap?
An Intermarket spread swap refers to the exchange of two bonds within two different sections of a similar market in an attempt to get a more positive yield spread. Generally, the swap is motivated If there happens to be a change in the market and/or change in the investment goals, then the investor sees it necessary to take on a different bond strategy. In other words, it is a business deal meant to capitalize or take advantage on yield differences between bond market segments. Using this strategy, an investor can be able to improve his position via diversification.
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How Does an Intermarket Spread Swap Work?
The yield spread is the variance between returns on various debt securities with changing maturities, credit rating, and risk. In market spread swaps, when one bond is viewed to be better, then another bond is sold in order to purchase the superior one. In this case, the basis of Intermarket spread swaps is, therefore, on the yield spread which exists between various bond sectors. Note that when parties enter a swap, they gain exposure to the underlying bonds, without holding securities directly. For Intermarket spread swap opportunities to exist, there must be credit quality or feature differences between bonds.
Example of how an Intermarket Spread Swap Works
An Intermarket spread trade may involve purchasing of a contract for X crude oil Company on the Chicago Mercantile Exchange whereas selling a contract for Y crude oil Company on the Intercontinental Exchange. In this case, rather than the two instruments losing or gaining value based on their price, it is their relative difference that will apply.
Ways of Executing Intermarket Spread Swap
Intermarket spread swap can be implemented in the following two ways:
- P-bond having a greater yield-to-maturity than the H-bond
This is where a bond has a great yield-to-maturity meaning there are extra yields. When applying this type of swap, there is always hope that the spread will either not widen or that the Intermarket spread will narrow, leading to a relatively lower yield-to-maturity for P-bond or a relatively higher price for P-bond.
- P-bond having a lower-yield-to-maturity than the H-bond
Here, the P-bond usually has a yield-to-maturity which is lower than the H-bond. For an investor to be able to benefit through this type of swap implementation, the yield spread must enlarge so as to ensure that the P-bond has relatively lower yields leading to high P-bond prices which would more than counterbalance the yield loss.
Uses of an Intermarket Spread Swaps
- Intermarket spread swaps can be used by investors to protect their investments in case of changes in the market or in the investment goals. The investor can swap one bond for another so as to maximize profits. This is especially when the bond is being exchanged for has a high potential of generating more profits.
- Investors can use Intermarket spread swap to compare credit ratings of different companies operating in the same sector.
Risks Associated with Intermarket Spread Swaps
One risk associated with an Intermarket spread swap is that it can sometimes be volatile. When both legs of the spread go in the opposite direction, it is an indication that the spread swap is unstable. It is, therefore, important to know the markets economic basics. The market economic basics here refer to potential spread changes such as periodic and historical price patterns. Another risk is that, in the process of buying and selling of these financial instruments, there is a possibility that you will lose either part of your investment or even worse, lose your entire investment.
In general, spread trade profits are generated from the widening or narrowing of the gap spread between the two financial instruments. When there is a right instrument combination in spread trading, it is bound to be successful. Note that the spread between the two contract instruments should generally fluctuate within a particular range. It is, therefore, important to choose financial instruments that are highly related and with common features.