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What Determines U.S. Swap Spreads?

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  • Adam Kobor
  • Lishan Shi
  • Ivan Zelenko
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    Abstract

    This paper examines the evolution of the U.S. interest swap market. The authors review the theory and past empirical studies on U.S. swap spreads, and estimate an error-correction model for maturities of 2, 5, and 10 years from 1994 to 2004. Financial theory depicts swaps as contracts indexed on London Inter-Bank Offered (LIBOR) rates, rendered almost free of counterparty default risk by mark-to-market and collateralization. Swap spreads reflect the LIBOR credit quality (credit component) and a liquidity convenience premium present in Treasury rates (liquidity component). Multifactor models that were estimated on observed swap rates highlighted the central role played by the liquidity component in explaining swap-spread dynamics over the past 15 years. The multifactor models also found some puzzling empirical results. Statistical models, on the other hand, based mainly on market analysis, faced technical difficulties arising from the presence of regime changes, from the non-stationary in swap spreads, and from the coexistence of long-term and shorter-term determinants. Against this background, the authors apply an error-correction methodology based on the concept of co-integration. They find that U.S. dollar swap spreads and the supply of U.S. Treasury bonds are co-integrated, suggesting that the Treasury supply is a key determinant on a long-term horizon. The authors estimate an error-correction model that integrates this long-term relationship with the influence of four shorter-term determinants: the AA spread, the repo rate, the difference between on-the-run and off-the-run yields, and the duration of mortgage-backed securities. The error-correction model fits observed swap spreads quite well over the sample period. The authors illustrate how the same model can be used to carry out scenario analysis.

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    Bibliographic Info

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    This book is provided by The World Bank in its series World Bank Publications with number 7272 and published in 2005.

    ISBN: 978-0-8213-6338-6
    Handle: RePEc:wbk:wbpubs:7272

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    References

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Anurag Gupta & Marti G. Subrahmanyam, 1999. "An Empirical Examination of the Convexity Bias in the Pricing of Interest Rate Swaps," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 99-001, New York University, Leonard N. Stern School of Business-.
    2. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, American Finance Association, vol. 47(3), pages 831-50, July.
    3. Marcelle Arak & Arturo Estrella & Laurie Goodman & Andrew Silver, 1988. "Interest rate swaps: an alternative explanation," Research Paper, Federal Reserve Bank of New York 8811, Federal Reserve Bank of New York.
    4. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, American Finance Association, vol. 52(4), pages 1287-1321, September.
    5. Cox, John C. & Ingersoll, Jonathan Jr. & Ross, Stephen A., 1981. "The relation between forward prices and futures prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 9(4), pages 321-346, December.
    6. Titman, Sheridan, 1992. " Interest Rate Swaps and Corporate Financing Choices," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1503-16, September.
    7. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 12(2-3), pages 231-254.
    8. John Kambhu, 2004. "Trading risk and volatility in interest rate swap spreads," Staff Reports, Federal Reserve Bank of New York 178, Federal Reserve Bank of New York.
    9. Hamilton, James D., 1990. "Analysis of time series subject to changes in regime," Journal of Econometrics, Elsevier, Elsevier, vol. 45(1-2), pages 39-70.
    10. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, Econometric Society, vol. 57(2), pages 357-84, March.
    11. Lang, Larry H. P. & Litzenberger, Robert H. & Luchuan Liu, Andy, 1998. "Determinants of interest rate swap spreads," Journal of Banking & Finance, Elsevier, Elsevier, vol. 22(12), pages 1507-1532, December.
    12. Neil Cooper & Cedric Scholtes, 2001. "Government bond market valuations in an era of dwindling supply," BIS Papers chapters, Bank for International Settlements, in: Bank for International Settlements (ed.), The changing shape of fixed income markets: a collection of studies by central bank economists, volume 5, pages 147-169 Bank for International Settlements.
    13. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, American Finance Association, vol. 56(3), pages 1095-1115, 06.
    14. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, American Finance Association, vol. 50(3), pages 789-819, July.
    15. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 921-49, July.
    16. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, American Finance Association, vol. 41(1), pages 19-37, March.
    17. Vincent Reinhart & Brian Sack, 2002. "The changing information content of market interest rates," BIS Papers chapters, Bank for International Settlements, in: Bank for International Settlements (ed.), Market functioning and central bank policy, volume 12, pages 340-357 Bank for International Settlements.
    18. Grinblatt, Mark, 1995. "An Analytic Solution for Interest Rate Swap Spreads," University of California at Los Angeles, Anderson Graduate School of Management, Anderson Graduate School of Management, UCLA qt9s13f3zx, Anderson Graduate School of Management, UCLA.
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