Hedging demand and near-zero swap spreads: Evidence from the Chinese interest rate swap market

Abstract

Interest rate swap plays an essential role in the Chinese fixed-income market as a mainly hedging instrument. However, the market pricing anomaly of the near-zero swap spread violates the non-arbitrage assumption. Investigating the dynamics of pricing factors on interest rate swaps is meaningful to explain near-zero swap spreads. This paper employs a vector autoregressive model with time-varying parameters (TVP-VAR) model to examine the dynamic effects of pricing factors on swap spreads from a business cycle perspective. An analysis of the main three swaps with 1-year, 2-year, and 5-years maturities indicates that the TVP-VAR model accurately describes the time-varying features of the economic determinants. The TVP-VAR model has higher forecasting accuracy than the TVP model, particularly in the first-three months after the start of Covid-19 pandemic. The level, interest rate volatility (or economic policy uncertainty index), and stock market volatility as the proxies for hedging demands show opposite effects to the theoretical predictions. These effects are evident before 2010 (international financial crisis), during a short period in 2015 (stock market crashes), and after 2019 (Covid-19 pandemic). Thus, we provide different explanations of the effects of the hedging demand on near-zero swap spreads.