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The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads

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Author Info
Jun Liu
Francis A. Longstaff
Ravit E. Mandell
Abstract

This paper studies the market price of credit risk incorporated into one of the most important credit spreads in the financial markets: interest rate swap spreads. Our approach consists of jointly modeling the swap and Treasury term structures using a general five-factor affine credit framework and estimating the parameters by maximum likelihood. We solve for the implied special financing rate for Treasury bonds and find that the liquidity component of on-the-run bond prices can be significant. We also find that credit premia in swap spreads are positive on average. These premia, however, vary significantly over time and were actually negative for much of the 1990s.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8990.

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Date of creation: Jun 2002
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Handle: RePEc:nbr:nberwo:8990

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E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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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.:
  1. Hua He, 2000. "Modeling Term Structures of Swap Spreads," Yale School of Management Working Papers ysm150, Yale School of Management. [Downloadable!]
  2. Fama, Eugene F., 1984. "Term premiums in bond returns," Journal of Financial Economics, Elsevier, vol. 13(4), pages 529-546, December. [Downloadable!] (restricted)
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  4. Longstaff, Francis A., 2000. "The term structure of very short-term rates: New evidence for the expectations hypothesis," Journal of Financial Economics, Elsevier, vol. 58(3), pages 397-415, December. [Downloadable!] (restricted)
  5. Mark Grinblatt, 2001. "An Analytic Solution for Interest Rate Swap Spreads," International Review of Finance, International Review of Finance Ltd., vol. 2(3), pages 113-149. [Downloadable!] (restricted)
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  6. Chapman, David A & Long, John B, Jr & Pearson, Neil D, 1999. "Using Proxies for the Short Rate: When Are Three Months Like an Instant?," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(4), pages 763-806.
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  7. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September. [Downloadable!] (restricted)
  8. Sun, Tong-sheng & Sundaresan, Suresh & Wang, Ching, 1993. "Interest rate swaps: An empirical investigation," Journal of Financial Economics, Elsevier, vol. 34(1), pages 77-99, August. [Downloadable!] (restricted)
  9. Pearson, N.D. & Sun, T.S., 1991. "An Empirical Examination of the Cox, Ingersoll and Ross Model of the Term Structure of Interest Rates," Papers fb-24, Columbia - Graduate School of Business.
  10. Longstaff, Francis A & Schwartz, Eduardo S, 1995. " A Simple Approach to Valuing Risky Fixed and Floating Rate Debt," Journal of Finance, American Finance Association, vol. 50(3), pages 789-819, July. [Downloadable!] (restricted)
  11. Buraschi, Andrea & Menini, Davide, 2002. "Liquidity risk and specialness," Journal of Financial Economics, Elsevier, vol. 64(2), pages 243-284, May. [Downloadable!] (restricted)
  12. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-49, July. [Downloadable!] (restricted)
  13. Bicksler, James & Chen, Andrew H, 1986. " An Economic Analysis of Interest Rate Swaps," Journal of Finance, American Finance Association, vol. 41(3), pages 645-55, July. [Downloadable!] (restricted)
  14. Monika Piazzesi, 2001. "An Econometric Model of the Yield Curve with Macroeconomic Jump Effects," NBER Working Papers 8246, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  15. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 12(4), pages 687-720.
  16. Darrell Duffie & Lasse Heje Pedersen & Kenneth J. Singleton, 2003. "Modeling Sovereign Yield Spreads: A Case Study of Russian Debt," Journal of Finance, American Finance Association, vol. 58(1), pages 119-159, 02. [Downloadable!] (restricted)
  17. Longstaff, Francis A & Schwartz, Eduardo S, 1992. " Interest Rate Volatility and the Term Structure: A Two-Factor General Equilibrium Model," Journal of Finance, American Finance Association, vol. 47(4), pages 1259-82, September. [Downloadable!] (restricted)
  18. Boudoukh, Jacob & Whitelaw, Robert F, 1993. "Liquidity as a Choice Variable: A Lesson from the Japanese Government Bond Market," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(2), pages 265-92. [Downloadable!] (restricted)
  19. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July. [Downloadable!] (restricted)
  20. Knez, Peter J & Litterman, Robert & Scheinkman, Jose Alexandre, 1994. " Explorations into Factors Explaining Money Market Returns," Journal of Finance, American Finance Association, vol. 49(5), pages 1861-82, December. [Downloadable!] (restricted)
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Cited by:
(explanations, 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.)

  1. Marta Gomez Puig, 2005. "Monetary Integration and the Cost of Borrowing," Working Papers in Economics 134, Universitat de Barcelona. Espai de Recerca en Economia. [Downloadable!]
    Other versions:
  2. Joseph Byrne & Alexandros Kontonikas & Alberto Montagnoli, 2007. "Unit Roots in Inflation and Aggregation Bias," Working Papers 2007_07, Department of Economics, University of Glasgow. [Downloadable!]
  3. Rohan Churm & Nikolaos Panigirtzoglou, . "Decomposing credit spreads," Bank of England working papers 253, Bank of England. [Downloadable!]
  4. John Kambhu, 2006. "Trading risk, market liquidity, and convergence trading in the interest rate swap spread," Economic Policy Review, Federal Reserve Bank of New York, issue May, pages 1-13. [Downloadable!]
  5. John Kambhu, 2004. "Trading risk and volatility in interest rate swap spreads," Staff Reports 178, Federal Reserve Bank of New York. [Downloadable!]
  6. Marta Gómez-Puig, . "The Impact of Monetary Union on EU-15 Sovereign Debt Yield Spreads," Working Papers on International Economics and Finance 05-11, FEDEA. [Downloadable!]
    Other versions:
  7. Ericsson, Jan & Reneby, Joel, 2003. "Valuing Corporate Liabilities," SIFR Research Report Series 15, Institute for Financial Research. [Downloadable!]
  8. Somnath Chatterjee, 2005. "An Investigation Into The Linkages Between Euro And Sterling Swap Spreads," Working Papers 2005_1, Department of Economics, University of Glasgow. [Downloadable!]
  9. Antulio N. Bomfim, 2003. "Counterparty credit risk in interest rate swaps during times of market stress," Finance and Economics Discussion Series 2003-09, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  10. Christopher F. Baum & Mustafa Caglayan & Andreas Stephan & Oleksandr Talavera, 2006. "Uncertainty Determinants of Corporate Liquidity," Working Papers 2006_1, Department of Economics, University of Glasgow. [Downloadable!]
    Other versions:
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