On the term structure of default premia in the Swap and Libor markets
AbstractExisting theories of the term structure of swap rates provide an analysis of the Treasury-swap spread based on either a liquidity convenience yield in the Treasury market, or default risk in the swap market. While these models do not focus on the relation between corporate yields and swap rates (the LIBOR-Swap spread), they imply that the term structure of corporate yields and swap rates should be identical. As documented previously (e.g. in Sun, Sundares and Wang (1993)) this is counter-factual. Here, we propose a simple model of the (complex) default risk imbedded in the swap term structure that is able to explain the LIBOR-swap spread. Whereas corporate bonds carry default risk, we argue that swaps should bear less default risk. In fact, we assume that swap contracts are free of default risk. Because swaps are indexed on "refreshed"-credit-quality LIBOR rates, the spread between corporate yields and swap rates should capture the market's expectations of the probability of deterioration in credit quality of a corporate bond issuer. We model this feature and use our model to estimate the likelihood of future deterioration in credit quality from the LIBOR-swap spread. The analysis is important because it shows that the term structure of swap rates does not reflect the borrowing cost of a standard LIBOR credit quality issuer. It also has implications for modeling the dynamics of the swap term structure.
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Bibliographic InfoPaper provided by HEC Paris in its series Les Cahiers de Recherche with number 704.
Length: 25 pages
Date of creation: 01 May 2000
Date of revision:
Credit risk; asset pricing; international finance;
Find related papers by JEL classification:
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
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