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

  • Liu, Jun
  • Longstaff, Francis A.
  • Mandell, Ravit E.
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This paper studies the market price of credit risk incorporated into one of the most important credit spreads in the financial markets: interestrate swap spreads. Our approach consists of jointly modeling the swap and Treasury term structures using a four-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 very significant. We show that most of the variation in swap spreads is driven by changes in the liquidity of Treasury bonds rather than changes in default risk. We find that there are positive credit premia in swap spreads on average. These premia, however, vary significantly over time and were negative for much of the 1990s. Since the hedge-fund crisis of 1998, credit premia have become positive and are currently at historical highs.

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Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt0zw4f9w6.

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Date of creation: 01 Oct 2000
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Handle: RePEc:cdl:anderf:qt0zw4f9w6
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Web page: http://www.escholarship.org/repec/anderson_fin/

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  11. 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.
  12. 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.
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  14. Pierre Collin-Dufresne, 2001. "On the Term Structure of Default Premia in the Swap and LIBOR Markets," Journal of Finance, American Finance Association, vol. 56(3), pages 1095-1115, 06.
  15. Mark Grinblatt, 2002. "An Analytic Solution for Interest Rate Swap Spreads," Yale School of Management Working Papers ysm39, Yale School of Management.
  16. Longstaff, Francis A & Santa-Clara, Pedro & Schwartz, Eduardo S, 2000. "The Relative Valuation of Caps and Swaptions: Theory and Empirical Evidence," University of California at Los Angeles, Anderson Graduate School of Management qt65f1914p, Anderson Graduate School of Management, UCLA.
  17. Vasicek, Oldrich, 1977. "An equilibrium characterization of the term structure," Journal of Financial Economics, Elsevier, vol. 5(2), pages 177-188, November.
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  22. 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.
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  25. 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.
  26. Duffie, Darrell & Singleton, Kenneth J, 1999. "Modeling Term Structures of Defaultable Bonds," Review of Financial Studies, Society for Financial Studies, vol. 12(4), pages 687-720.
  27. David A. Chapman & John B. Long Jr. & Neil D. Pearson, 1998. "Using Proxies for the Short Rate: When are Three Months Like an Instant?," Finance 9808004, EconWPA, revised 07 Oct 1998.
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