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Common risk factors in the US and UK interest rate swap markets:Evidence from a non-linear vector autoregression approach

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  • Ilias Lekkos
  • Costas Milas

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Abstract

This paper produces evidence in support of the existence of common risk factors in the US and UK interest rate swap markets. Using a multivariate smooth transition autoregression (STVAR) framework, we show that the dynamics of the US and UK swap spreads are best described by a regime-switching model. We identify the existence of two distinct regimes in US and UK swap spreads; one characterized by a "flat" term structure of US interest rates and the other characterized by an "upward" slopping US term structure. In addition, we show that there exist significant asymmetries on the impact of the common risk factors on the US and UK swap spreads. Shocks to UK oriented risk factors have a strong effect on the US swap markets during the "flat" slope regime but a very limited effect otherwise. On the other hand, US risk factors have a significant impact on the UK swap markets in both regimes. Despite their added flexibility, the STVAR models do not consistently produce superior forecasts compared to less sophisticated autoregressive (AR) and vector autoregressive (VAR) models.

Suggested Citation

  • Ilias Lekkos & Costas Milas, 2002. "Common risk factors in the US and UK interest rate swap markets:Evidence from a non-linear vector autoregression approach," Public Policy Discussion Papers 02-05, Economics and Finance Section, School of Social Sciences, Brunel University.
  • Handle: RePEc:bru:bruppp:02-05
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    Cited by:

    1. Ilias Lekkos & Costas Milas & Theodore Panagiotidis, 2007. "Forecasting interest rate swap spreads using domestic and international risk factors: evidence from linear and non-linear models," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 26(8), pages 601-619.
    2. Piotr PÅ‚uciennik, 2012. "The Impact of the World Financial Crisis on the Polish Interbank Market: A Swap Spread Approach," Central European Journal of Economic Modelling and Econometrics, CEJEME, vol. 4(4), pages 269-288, December.
    3. Sohel Azad, A.S.M. & Batten, Jonathan A. & Fang, Victor & Wickramanayake, Jayasinghe, 2015. "International swap market contagion and volatility," Economic Modelling, Elsevier, vol. 47(C), pages 355-371.

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