Modeling Term Structures of Swap Spreads

Abstract

Swap spreads, the interest rate differentials between the fixed rates on fixed-for-floating swap contracts and the yeilds-to-maturity on maturity-matched government bonds, define a market for one of the most actively transacted securities in the global fixed-income arena. A large universe of fixed-income securities including corporate bonds and mortgaged-back securities use interest rate swap spreads as a key benchmark for pricing and hedging. Swap spreads have received renewed attention since the Fall of 1998 when their volatile movements contributed in a significant way to the financial turmoil that led the US Fed to cut short-term interest rates by 75 basis points. In this paper we present new insights on how to analyze term structure of interest swap spreads. Specificaly, we focus on the determinants of swap spreads and show how quantities such as the spread of short-term LIBOR over GC-repo rates, the liquidity premium commended by government bond, and the risk premium required for holding long-term bonds/swaps jointly determine term structures of swap spreads.