Abstract
This paper argues that liquidity differences between government securities and short Eurodollar borrowings account for interest rate spreads. It then models the convenience of liquidity as a linear function of two mean-reverting state variables and values it. The interest rate spread for a 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 structure models. Numerical values for the parameters in both special cases illustrate that many realistic swap spread structures can be replicated. Model parameters are estimated using weekly data on the term structure of spreads from several countries. The model fits the data well.
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