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Understanding liquidity and credit risks in the financial crisis

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  • Gefang, Deborah
  • Koop, Gary
  • Potter, Simon M.

Abstract

This paper develops a structured dynamic factor model for the spreads between London Interbank Offered Rate (LIBOR) and overnight index swap (OIS) rates for a panel of banks. Our model involves latent factors which reflect liquidity and credit risk. Our empirical results show that surges in the short term LIBOR-OIS spreads during the 2007–2009 financial crisis were largely driven by liquidity risk. However, credit risk played a more significant role in the longer term (twelve-month) LIBOR-OIS spread. The liquidity risk factors are more volatile than the credit risk factor. Most of the familiar events in the financial crisis are linked more to movements in liquidity risk than credit risk.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Empirical Finance.

Volume (Year): 18 (2011)
Issue (Month): 5 ()
Pages: 903-914

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Handle: RePEc:eee:empfin:v:18:y:2011:i:5:p:903-914

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Web page: http://www.elsevier.com/locate/jempfin

Related research

Keywords: Dynamic factor model; LIBOR-OIS spread; Credit default swap;

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Cited by:
  1. Prokopczuk, Marcel & Siewert, Jan B. & Vonhoff, Volker, 2013. "Credit risk in covered bonds," Journal of Empirical Finance, Elsevier, vol. 21(C), pages 102-120.
  2. Muto, Ichiro, 2012. "A Simple Interest Rate Model with Unobserved Components: The Role of the Interbank Reference Rate," MPRA Paper 43220, University Library of Munich, Germany.

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