by: Adam Kobor, Lishan Shi, Ivan Zelenko
This title examines the evolution of the U.S. interest swap market.
It reviews the theory and past empirical studies on U.S. swap spreads
and estimates an error correction model for maturities of 2-, 5- and
10-year over the period 1994-2004. Financial theory depicts swaps as
contracts indexed on LIBOR rates, rendered almost free of counterparty
default risk by mark-to-market and collateralization. Swap spreads
reflect the LIBOR credit quality (credit component) and a liquidity
convenience premium present in Treasury rates (liquidity component).
Multifactor models which were estimated on observed swap rates
highlighted the central role played by the liquidity component in
explaining swap spread dynamics over the past fifteen years. They also
found, however, some puzzling empirical results. Statistical models, on
the other hand, mainly based on market analysis, faced technical
difficulties, arising from the presence of regime changes, the
non-stationarity in swap spreads, and the co-existence of long-term and
Against this background, the authors applied the error correction
methodology based on the concept of cointegration. They find that U.S.
dollar swap spreads and the supply of U.S. Treasury bonds are
cointegrated, suggesting that the Treasury supply is a key determinant
on a long-term horizon. They then estimate an error correction model
which integrates this long-term relationship with the influence of four
shorter-term determinants: the AA spread, the repo rate, the difference
between on-the-run and off-the-run yields, and the duration of mortgage
backed securities. The error correction model fits observed swap
spreads quite well over the sample period. The authors then illustrate
how the same model can be used to carry out scenario analysis.
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