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Understanding Liquidity and Credit Risks in the Financial Crisis

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Author Info

  • Deborah Gefang

    ()
    (Department of Economics, University of Lancaster)

  • Gary Koop

    ()
    (Department of Economics, University of Strathclyde)

  • Simon Potter

    ()
    (Research and Statistics Group, Federal Reserve Bank of New York)

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 relect 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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File URL: http://www.strath.ac.uk/media/departments/economics/researchdiscussionpapers/2011/11-14_Final.pdf
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Bibliographic Info

Paper provided by University of Strathclyde Business School, Department of Economics in its series Working Papers with number 1114.

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Length: 27 pages
Date of creation: Apr 2011
Date of revision:
Handle: RePEc:str:wpaper:1114

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Related research

Keywords: LIBOR-OIS spread; factor model; credit default swap; Bayesian;

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Cited by:
  1. 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.
  2. Prokopczuk, Marcel & Siewert, Jan B. & Vonhoff, Volker, 2013. "Credit risk in covered bonds," Journal of Empirical Finance, Elsevier, vol. 21(C), pages 102-120.

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