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Can you please explain the following? Please assume I am 5 years old.

  1. how do you derive the cuts/hikes of the policy rate priced in a swap curve?
  2. why you can derive the cuts/hikes only from a swap curve and not from a bond curve (some emerging/frontier markets don't have swaps)?
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  • $\begingroup$ You might find this question useful. Generally though, this forum isn't for ELI5 type questions, and money se would be better suited for this. Bonds don't directly relate to interest rates like the fed funds rate. $\endgroup$
    – AKdemy
    Oct 12, 2023 at 22:07

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Compute the swap rate from 1 cb date to the next, to imply the effective rate (you may need to add subtract a spread I.e. in USD, interbank swaps are traded versus SOFR or FF, if you use SoFR, typically that trades under FF and the fixing will be lower too). That implied fwd swap should give you the markets pricing of a what the average fixing over 1m or so should be. So say EFFR is 5.33 atm, the swap says 5.36. Assuming 25bps as a hike the probability of that happening is 12%.

Alternatively you could use the futures market.

Really depends on liquidity and index the swap references. Also, creating a swap curve is A LOT easier than a bond curve. In US for eg. I'd say swaps and futures are considerably more liquid than short end bonds and trade far more volume than any issue at the short end generally.

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  • $\begingroup$ from what I understand with spot starting swap rates you calculate fwd starting swaps and then derive the cuts\hikes. Besides liquidity issues, what prevents you from using bond spot yields to calculate fwd starting bond yields? Is there any mathematical constraints/ product difference? $\endgroup$ Oct 12, 2023 at 18:37
  • $\begingroup$ Yes. Fwd starting swaps are a function of spot starting swaps. Why don't u do this one as an excercise..how many bonds / bills do you find with an expiry in between the next fed and following..also what rate is the bond funded at ? $\endgroup$
    – user68819
    Oct 12, 2023 at 19:10
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    $\begingroup$ Answer: creating a representative bond curve is hard. You will have numerous issues etc which are not in line in a yield sense due to coupon differences, repo differences, supply, liquidity etc. Swaps/futures that way are really just created as open interest $\endgroup$
    – user68819
    Oct 12, 2023 at 19:25

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