Quality Spread Differential - QSD
Categories: Metrics
An interest rate swap involves two parties trading the proceeds of two interest-bearing investments. Typically, one party will have a fixed-rate holding, while the other one will have an investment that carries a floating rate.
In true "the grass is always greener" style, the two parties look longingly at each other's investment. The floating-rate holder wants the security and piece of mind that comes with a fixed rate. The person with the fixed-rate investment wants the excitement and potential upside of the floating rate.
So, like in a 1980s body-swap comedy, they switch. The holder of the floating rate now gets the cash generated from the fixed-rate investment, and vice versa. They don't trade the actual investments...just the money generated by the investments. All well and good so far. But there's a problem. The two investments might have different credit qualities. That is, one of the investments might carry a higher default risk for the other. The investors need a way to test whether the credit quality for both sides makes the deal worthwhile.
Enter the quality spread differential. It's an equation that quantifies the difference between the credit quality of the investments involved in the swap. The figure equates to the difference between the debt premium differential for the fixed-rate investment and the debt premium differential for the floating-rate one. If the QSD is positive (that is, if it's above zero, i.e. if the fixed-rate debt premium differential is higher than the floating-rate one), then the swap makes sense.
Related or Semi-related Video
Finance: What is Spread?48 Views
finance a la shmoop. what is spread? before we start just no. get your mind
out of the gutter. spread refers to the money value between [100 dollar bill]
a bid and ask price under a market maker structure of trading securities. no more
wire hangers, a plastic hanger company is publicly traded on an exchange like
Nasdaq where buyers bid for a price to purchase and sellers ask for a price to [Nasdaq wall shown]
trade. no more wire hangers is bid this moment at 37:23 a share by buyers
willing to buy right now at that price and is being asked at this moment at a
price of 37.31. note the eight cents a shared difference in the share prices.
that dif is the spread between the two prices, and it's worth noting that in [bread is buttered]
extremely volatile stocks, the spread widens. and in boring highly liquid
stocks which don't move much, the spread tightens or is narrower. that is on a
volatile equivalent of no more wire hangers the spread might grow to 20 or
30 cents a share whereas a boring name that pays a big dividend and the stock
never moves much we're thinking AT&T here, [man snores at a desk]
well that spread might be just three or four cents. so why grow? well because a
market maker in a volatile stock doesn't want to be caught losing money on her
inventory. if no more wire hangers suddenly gapped down to 37.10 a share [equation shown]
well it would be likely less than the average of what the market maker paid
for her quote "inventory" unquote in that stock from which he was making a market
in it. each time the shares trade the market makers dip into that spread to [woman dips cracker in butter]
pay their bills and allow them to keep doing business. so that's spread. and it's
not the type that Prince used to sing about. [man on stage]