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What Drives Hong Kong Dollar Swap Spreads: Credit or Liquidity?

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  • Cho-Hoi Hui

    (Research Department, Hong Kong Monetary Authority)

  • Lillie Lam

    (Research Department, Hong Kong Monetary Authority)

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    Abstract

    This paper investigates the determinants of variations in the yield spreads (swap spreads) between Hong Kong dollar interest rate swaps and Exchange Fund paper for a period from July 2002 to April 2008. A vector error-correction model is used to analyse the impact of various shocks on swap spreads. The issue is whether "liquidity" or "credit" (or both) is the main determinant of swap spread dynamics. The results show that the dynamics are influenced significantly by "credit" between July 2002 and September 2007. However, "liquidity" between the Exchange Fund long-term notes and short-term bills is the major determinant of swap spreads between September 2007 and April 2008. The substantial demand of the Exchange Fund short-term bills, that reflected the strong preference of market participants for holding short-term instruments for liquidity purposes probably due to the sub-prime crisis in the US, is the driving force of the rise in swap spreads in the last quarter of 2007.

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    File URL: http://www.info.gov.hk/hkma/eng/research/working/pdf/HKMAWP08_10_full.pdf
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    Bibliographic Info

    Paper provided by Hong Kong Monetary Authority in its series Working Papers with number 0810.

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    Length: 21 pages
    Date of creation: Jul 2008
    Date of revision:
    Handle: RePEc:hkg:wpaper:0810

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    Related research

    Keywords: Hong Kong dollar interest rates; swap spreads; vector error-correction model; sub-prime crisis;

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    References

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    1. Jushan Bai, 1995. "Estimating Multiple Breaks One at a Time," Working papers 95-18, Massachusetts Institute of Technology (MIT), Department of Economics.
    2. Lang, Larry H. P. & Litzenberger, Robert H. & Luchuan Liu, Andy, 1998. "Determinants of interest rate swap spreads," Journal of Banking & Finance, Elsevier, vol. 22(12), pages 1507-1532, December.
    3. Feldhütter, Peter & Lando, David, 2008. "Decomposing swap spreads," Journal of Financial Economics, Elsevier, vol. 88(2), pages 375-405, May.
    4. Perron, P. & Bai, J., 1995. "Estimating and Testing Linear Models with Multiple Structural Changes," Cahiers de recherche 9552, Universite de Montreal, Departement de sciences economiques.
    5. Perron, Pierre, 1989. "The Great Crash, the Oil Price Shock, and the Unit Root Hypothesis," Econometrica, Econometric Society, vol. 57(6), pages 1361-1401, November.
    6. Duffie, Darrell & Singleton, Kenneth J, 1997. " An Econometric Model of the Term Structure of Interest-Rate Swap Yields," Journal of Finance, American Finance Association, vol. 52(4), pages 1287-1321, September.
    7. BAI, Jushan & PERRON, Pierre, 1998. "Computation and Analysis of Multiple Structural-Change Models," Cahiers de recherche 9807, Universite de Montreal, Departement de sciences economiques.
    8. Huang, Ying & Neftci, Salih N. & Guo, Feng, 2008. "Swap curve dynamics across markets: Case of US dollar versus HK dollar," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 18(1), pages 79-93, February.
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