Modelling Australian interest rate swap spreads by mixture autoregressive conditional heteroscedastic processes

Abstract

The observed difference between the swap rate and the government bond yield of corresponding maturity is known as the swap spread. The swap spread reflects the risk premium that is involved in a swap transaction instead of holding risk-free government bonds. It is primarily composed of the liquidity risk premium and the credit risk premium. In recent years there has been growing interest in modelling swap spreads because the swap spread is the key pricing variable for the swap rate. The Australian interest rate swap market is the most important over-the-counter (OTC) derivative market in Australia. In this paper we apply the class of mixture autoregressive conditional heteroscedastic (MARCH) models to three (3-year, 5-year and 10-year) swap spread series in Australia. The MARCH model is able to capture both of the stylised characteristics of the observed changes of the swap spread series: volatility persistence and the dependence of volatility on the level of the data. The proposed MARCH model also allows for regime switches in the swap spreads.