Essay About Fundamental Values And Interest Rate Swap Spread

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Many academics and policymakers think that asset prices have deviated significantly from
“fundamental values” and that this deviation is part of the problem affecting financial
institutions. For example, if mortgage and credit assets, which banks hold in plenty, are
currently priced below “fundamental values,” then banks will be assessed larger losses than
they otherwise would. This in turn can lead to binding bank capital requirements, concerns over
banks defaulting, etc.
But, what is fundamental value, and how can one make these sorts of statement? The notion
that one can accurately assess fundamental value on the most toxic mortgage-backed securities
should be rightly treated with some suspicion. However, there is considerable evidence that
arbitrage forces, which we normally take to be the key enforcer of fundamental value
relationships, are not present in todays environment. This is circumstantial evidence for
fundamental value deviations.
Below I discuss two pricing relationships which reflect these distortions. The examples are
somewhat involved; but bear with me because they are not as complicated as they sound, and
they are illuminating.
Figure 1 graphs the interest rate swap spread for maturities of 5 years and 30 years. The 30
year swap spread measures the difference between 30 year Treasury rates and 30 year fixedfor-
floating (LIBOR) interest rate swap rates. Since the swap rate reflects LIBOR which in turn
reflects bank credit risk, swap rates are almost always higher than Treasury rates. However,
since September there are a number of dates on which the 30 year swap rates have been below
Treasury rates (while the usual pricing pattern prevailed for all other maturities