Transmission of Shocks to LIBOR Risk Spreads and Nominal Risk-Free Rates

Abstract

In this study, effects of shocks to international money market conditions, as measured by the three-month London Interbank Offer Rates (LIBOR) for five financially integrated economies (United States, the euro zone countries, Great Britain, Japan, and Canada) are examined. The sample period runs from January 4, 1999, through December 31, 2010. A fiveequation vector autoregressive (VAR) model is developed using daily risk spreads between each country’s LIBOR and its nominal risk-free rate. Also, effects of the risk spreads on the respective nominal risk-free rates are identified in a separate VAR system. Based on the risk-spread VAR, effects of exogenous shocks are examined. Single-country impulse tests show that the feedthrough effects on the other countries are surprisingly limited for these integrated countries. Only when a shock is applied concurrently to all five risk spreads can effects on the magnitude noted in 2008 and 2009 be replicated, suggesting that all LIBOR rates were affected by a contemporaneous shock. Finally, a proportion of the shock to the risk-spread feed has an inverse effect on each country’s nominal risk-free rate, reflecting the effect of the flow of funds from risky assets to safe assets in a time of increased risk and vice versa.