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An Analytic Solution for Interest Rate Swap Spreads

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  • Mark Grinblatt

Abstract

This paper argues that liquidity differences between government securities and short term Eurodollar borrowings account for interest rate swap spreads. It then models the convenience of liquidity as a linear function of two mean-reverting state variables and values it. The interest rate swap spread for a swap of particular maturity is the annuitized equivalent of this value. It has a closed form solution: a simple integral. Special cases examined include the Vasicek (1977) and Cox-Ingersoll-Ross (1985) one-factor term structure models. N
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  • 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.
  • Handle: RePEc:bla:irvfin:v:2:y:2001:i:3:p:113-149
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    1. John C. Cox & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2005. "A Theory Of The Term Structure Of Interest Rates," World Scientific Book Chapters,in: Theory Of Valuation, chapter 5, pages 129-164 World Scientific Publishing Co. Pte. Ltd..
    2. Kamara, Avraham, 1994. "Liquidity, Taxes, and Short-Term Treasury Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(03), pages 403-417, September.
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    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, vol. 52(4), pages 1287-1321, September.
    5. Sarig, Oded & Warga, Arthur, 1989. "Bond Price Data and Bond Market Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 367-378, September.
    6. Mark Grinblatt & Francis A. Longstaff, 2000. "Financial Innovation and the Role of Derivative Securities: An Empirical Analysis of the Treasury STRIPS Program," Journal of Finance, American Finance Association, vol. 55(3), pages 1415-1436, June.
    7. Cooper, Ian A & Mello, Antonio S, 1991. " The Default Risk of Swaps," Journal of Finance, American Finance Association, vol. 46(2), pages 597-620, June.
    8. 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.
    9. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-850, July.
    10. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
    11. Vasicek, Oldrich Alfonso, 1977. "Abstract: An Equilibrium Characterization of the Term Structure," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 12(04), pages 627-627, November.
    12. Robert A. Jarrow & Fan Yu, 2008. "Counterparty Risk and the Pricing of Defaultable Securities," World Scientific Book Chapters,in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 20, pages 481-515 World Scientific Publishing Co. Pte. Ltd..
    13. Warga, Arthur, 1992. "Bond Returns, Liquidity, and Missing Data," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 27(04), pages 605-617, December.
    14. 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.
    15. Duffie, Darrell & Huang, Ming, 1996. " Swap Rates and Credit Quality," Journal of Finance, American Finance Association, vol. 51(3), pages 921-949, July.
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