Estimating Policy Rate Moves from Short-Dated Swap Rates

Summary

The document describes a simple way to infer market pricing of policy rate changes from swap rates spanning consecutive central bank decision dates. The forward swap rate approximates the expected average reference-rate fixing over the period. Comparing it with the current effective rate, and assuming a particular hike or cut size, allows an implied probability to be estimated. The example uses a small difference between the current rate and the forward rate to illustrate the calculation; interest rate futures are mentioned as an alternative source.

The estimate depends on the swap's reference index, any spread between that index and the policy rate, and market liquidity. The response says that in the United States swaps and futures can be more liquid than short-dated bonds, and that constructing a swap curve can be easier. This is a practical market convention rather than a general proof that policy expectations can only be inferred from swaps: bond curves can also contain rate information, though liquidity and other pricing effects may complicate interpretation. The excerpt gives no fuller adjustment method or treatment of risk premia.

Key ideas

• Forward swap rates between policy decision dates can indicate the market-implied average reference rate for the interval.
• A rate difference can be translated into an implied probability only after assuming a size for the policy move.
• The inferred rate depends on the swap's reference index and any spread to the central bank policy rate.
• Futures provide an alternative market source for policy expectations.
• Swap curves may be easier to construct and more liquid than short-end bond curves in some markets.

Tags

# Deriving central bank hikes/cuts from a swap curve


# Deriving central bank hikes/cuts from a swap curve












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

- how do you derive the cuts/hikes of the policy rate priced in a swap curve?

- 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)?

## Answer by user68819 (score 2)

https://quant.stackexchange.com/a/76984

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.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.