Quality Spread Differential - QSD

An interest rate swap involves two parties trading the proceeds of two interest-bearing investments. Typically, one party will have a fixed-rate holding, while the other one will have an investment that carries a floating rate.

In true "the grass is always greener" style, the two parties look longingly at each other's investment. The floating-rate holder wants the security and piece of mind that comes with a fixed rate. The person with the fixed-rate investment wants the excitement and potential upside of the floating rate.

So, like in a 1980s body-swap comedy, they switch. The holder of the floating rate now gets the cash generated from the fixed-rate investment, and vice versa. They don't trade the actual investments...just the money generated by the investments. All well and good so far. But there's a problem. The two investments might have different credit qualities. That is, one of the investments might carry a higher default risk for the other. The investors need a way to test whether the credit quality for both sides makes the deal worthwhile.

Enter the quality spread differential. It's an equation that quantifies the difference between the credit quality of the investments involved in the swap. The figure equates to the difference between the debt premium differential for the fixed-rate investment and the debt premium differential for the floating-rate one. If the QSD is positive (that is, if it's above zero, i.e. if the fixed-rate debt premium differential is higher than the floating-rate one), then the swap makes sense.