Decomposing the Default Risk and Liquidity Components of Interest Rate Swap Spreads

Abstract

This paper develops a reduced form model of interest rate swap spreads. The model accommodates both the default risk inherent in swap contracts and the liquidity difference between the swap and Treasury markets. We use an extended Kalman filter approach to estimate the model parameters. The model fits the swap rates well. We then solve for the implied general collateral repo rates and use them to decompose the swap spreads into their default risk and liquidity components. This exercise shows that the default risk and liquidity components of swap spreads behave very differently: although default risk accounts for the largest share of the levels of swap spreads, the liquidity component is much more volatile. In addition, while the default risk component has been historically positive, the liquidity component was negative for much of the 1990s and has become positive since the financial market turmoils in 1998.