It was mentioned in the core reading that the S2 guideline is still deciding between swap rate and government bond yield as the discounting rate for liabilities. I have a few questions regarding this,
1) What exactly is a swap rate?
As you mention below, a swap involves exchanging a fixed interest rate for a floating interest rate.
The swap curve that is used in discounting is the curve of the fixed rates for swaps of different terms. Therefore if we want to discount a cashflow at time 5, we would used the fixed interest rate from a 5 year swap.
2) Why are we using swap rate to discount our cashflows?
The CFO Forum gave the following justification for using the swap curve instead of the gilt curve.
ADVANTAGES
Swap markets are more liquid than government bond markets.
Swaps are synthetic instruments which do not suffer from systematic distortions due to insufficient supply or regulatory factors.
Swap prices are consistent with how traded options are quoted which is the basis for the market-consistent valuation approach.
Many companies are already using swaps and this is aligned with where the market appears to be heading.
The use of swaps is consistent with using implied volatilities.
DISADVANTAGES
Swap yields contain a small margin for credit risk.
In some markets (for example, in Asia), swaps are not available at long (e.g. over 10 years) durations or at all.
3) I understand interest rate swap where fixed interest rate is being swapped for floating rate. What is the relationship between swap rates and discounting rates?
The swap rate is just a point on the swap curve. So, if we want to discount a cashflow at time 5, we would used the fixed interest rate from a 5 year swap, ie a five year swap rate.
Best wishes
Mark
