Why Swap Curves and Government Bond Curves Serve Different Valuations
Summary
The document discusses why discount-curve choice depends on the liabilities or assets being valued. For active bank trading books, it emphasizes using curves that support accurate, consistent mark-to-market valuations across operations. It contrasts this with pension liabilities, for which a prescribed ultimate forward rate curve can reduce valuation volatility and avoid frequent rehedging that would add transaction costs. The answer describes this as a regulatory and valuation context rather than a universal rule for all instruments.
For euro-area valuations, swap curves are presented as a way to compare consistently across countries whose government bond yields differ with their fiscal positions. The answer also favors swaps where their curves are smooth, well-defined, and actively traded, while some sovereign bond curves may be sparse or distorted by bond-specific features. It does not supply quantitative comparisons or establish that swap curves are always preferable; the appropriate curve depends on valuation purpose and market context.
Key ideas
- Discount curves should reflect the assets, liabilities, and valuation context being considered.
- Active trading desks benefit from curves that support consistent, current mark-to-market valuations.
- A prescribed ultimate forward rate curve for pension liabilities can limit valuation swings and rehedging costs.
- Swap curves can support cross-country consistency when sovereign yields vary with country risk.
- Sparse or bond-specific trading can make some government bond curves less smooth or representative.
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Full text
# Price compounding: Swap versus Governments Bonds # Price compounding: Swap versus Governments Bonds There are different rates curve to compound prices. Since the crisis, regulators tends to favor price compounding with swap curves over IR curves deduced from governments bonds (EU regulators, french bonds for example). What is the rationale behind this choice ? Is this to avoid negative rates ? Is this to avoid a risk premium on countries ? To include a risk premium on banks ? A liquidity problem ? An easy solution as swap are directly quoted in Bloomberg / Reuters ? ## Answer by Attack68 (score 2) https://quant.stackexchange.com/a/37479 Often the choice of discount curves are dependent upon the context of the assets/liabilities being valued. Banks, for example who have active and to-the-second accurate valuations of these due to active trading desks reporting daily mark-to-market should have more accurate curves, so that all of their operations are consistently valued and do not lead to systematic loopholes with respect to reporting. Pension liabilities in Euroland for example are discounted with an 'ultimate forward rate' (UFR) curve which sets a minimum constant rate at which to discount liabilities. In this context there are two major reasons; it reduces the volatility of the valuations prohibiting constant rehedging (which would be more transaction costs for pensioners) and also given the current level of low rates (and high discount factors) it allows all European pension funds from avoiding reporting perilously low levels of capital compared with the 'true' value of liabilities. Choosing swap curves over bonds curves in Euroland also has two major advantages; 1) it allows consistent valuation from country to country even when the respective countries' GBs have considerably different yield levels, due to each respective state's financial position. 2) Swap curves are well defined, smooth and have an active market, whereas some countries' bond curves are sparsely populated and somewhat irrational accounting for the commodity like nature of certain bonds with certain coupons, etc.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.