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On the term structure of default premia in the Swap and Libor markets

  • SOLNIK, Bruno
  • COLLIN-DUFRESNE, Pierre
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    Existing theories of the term structure of swap rates provide an analysis of the Treasury-swap spread based on either a liquidity convenience yield in the Treasury market, or default risk in the swap market. While these models do not focus on the relation between corporate yields and swap rates (the LIBOR-Swap spread), they imply that the term structure of corporate yields and swap rates should be identical. As documented previously (e.g. in Sun, Sundares and Wang (1993)) this is counter-factual. Here, we propose a simple model of the (complex) default risk imbedded in the swap term structure that is able to explain the LIBOR-swap spread. Whereas corporate bonds carry default risk, we argue that swaps should bear less default risk. In fact, we assume that swap contracts are free of default risk. Because swaps are indexed on "refreshed"-credit-quality LIBOR rates, the spread between corporate yields and swap rates should capture the market's expectations of the probability of deterioration in credit quality of a corporate bond issuer. We model this feature and use our model to estimate the likelihood of future deterioration in credit quality from the LIBOR-swap spread. The analysis is important because it shows that the term structure of swap rates does not reflect the borrowing cost of a standard LIBOR credit quality issuer. It also has implications for modeling the dynamics of the swap term structure.

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    File URL: http://www.hec.fr/var/fre/storage/original/application/6591ecebd339c7b522afabbfff0b7f79.pdf
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    Paper provided by HEC Paris in its series Les Cahiers de Recherche with number 704.

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    Length: 25 pages
    Date of creation: 01 May 2000
    Date of revision:
    Handle: RePEc:ebg:heccah:0704
    Contact details of provider: Postal: HEC Paris, 78351 Jouy-en-Josas cedex, France
    Web page: http://www.hec.fr/

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    1. Hugues Pirotte & Didier Cossin, 1997. "Swap Credit Risk: An Empirical Investigation on Transaction Data," Working Papers CEB 97-001, ULB -- Universite Libre de Bruxelles.
    2. Grinblatt, Mark, 1995. "An Analytic Solution for Interest Rate Swap Spreads," University of California at Los Angeles, Anderson Graduate School of Management qt9s13f3zx, Anderson Graduate School of Management, UCLA.
    3. 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.
    4. Duffee, Gregory R, 1999. "Estimating the Price of Default Risk," Review of Financial Studies, Society for Financial Studies, vol. 12(1), pages 197-226.
    5. Narasimhan Jegadeesh & George G. Pennacchi, 1996. "The behavior of interest rates implied by the term structure of Eurodollar future," Proceedings, Federal Reserve Bank of Cleveland, issue Aug, pages 426-451.
    6. 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.
    7. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-70, May.
    8. Langetieg, Terence C, 1980. " A Multivariate Model of the Term Structure," Journal of Finance, American Finance Association, vol. 35(1), pages 71-97, March.
    9. Sarig, Oded & Warga, Arthur, 1989. " Some Empirical Estimates of the Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 44(5), pages 1351-60, December.
    10. Jarrow, Robert A & Lando, David & Turnbull, Stuart M, 1997. "A Markov Model for the Term Structure of Credit Risk Spreads," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 481-523.
    11. Gregory R. Duffee, 1998. "The Relation Between Treasury Yields and Corporate Bond Yield Spreads," Journal of Finance, American Finance Association, vol. 53(6), pages 2225-2241, December.
    12. Litzenberger, Robert H, 1992. " Swaps: Plain and Fanciful," Journal of Finance, American Finance Association, vol. 47(3), pages 831-50, July.
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