The fixed-rate portion of an interest rate swap is intimately tied to the yield curve, and is set at the outset based on the market's future expectations of interest rates.

The pricing of the swap transaction is similar to the sale of interest rate futures contracts, with each payment exchange during the swap agreement equivalent to a single futures contract.

For example, a two-year swap based on the Public Securities Association's Municipal Swap Index might require the parties to exchange payments four times -- after six months, after one year, after one and a half years, and after two years. On each date, one side will pay a fixed rate and the other side will pay the PSA rate.

An issuer could use the swap to lock in a fixed rate on floating-rate debt that will be outstanding for the next two years. The notional value of the swap would equal the principal amount of outstanding bonds and would have the same payment dates.

Instead of entering the swap, the issuer could purchase interest rate futures contracts for each of the bond payment dates. At maturity, each contract would pay based on the current level of the PSA index. [This swap alternative is more theoretical than real. Although futures are available based on The Bond Buyer's long-term bond index, there is no market for PSA futures contracts.]

The issuer would "buy" each forward contract for a price that is fixed. That current price is derived from the market's expectations of future rates.

One contract would be due in six months. Its value would be based on the six-month forward rate for the PSA index. Another contract would be due in one year and its value would be based on the one-year forward PSA rate.

The pricing of the fixed-rate portion of an interest rate swap, therefore, is based on the costs associated with the theoretical purchase of futures contracts matching the terms of the swap agreement.

Forward rates do not always move in tandem with current market rates, because they are derived from the yield curve. If rates rise, but the slope of the yield curve changes, forward rates could decrease.

So too, swap rates do not always move in tandem with changes in current rates.

Over the past two weeks, the rate a single-A issuer would pay on a 10-year bond dropped from 5.65% to 5.45%, according to Municipal Market Data. At the same time, the rate a generic issuer would pay on a 10-year fixed-rate swap dropped from 5.33% to 5.17%.

Why did the bond rate drop more over the same period? While supply and demanded factors obviously affect both markets, part of the answer lies in the yield curve and its implied forward rates.

While long-term bond rates fell, short-term rates fell even faster. The PSA index declined from 2.98% to 2.60% over the past two weeks. That steepened the tax-exempt yield curve, putting some upward pressure on forward rates.

Overall, since long-and short-term rates declined, forward rates also declined. But because the shape of the yield curve changed -- with short-term rates falling farther than long-term rates -- forward rates did not decline as much as their current market counterparts.

Complicating the picture, tax-exempt swap rates are also affected by rates in the taxable market. That's because most hedging instruments used by swap dealers, especially futures contracts on short-term rates, are traded in the taxable market. The similar products based on tax-exempt rates are too illiquid to support a similar market.

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