Working Paper: CEPR ID: DP14105
Authors: Patrick Augustin; Mikhail Chernov; Lukas Schmid; Dongho Song
Abstract: Since the Global Financial Crisis, rates on interest rate swaps have fallen below maturity matched U.S. Treasury rates across different maturities. Swap rates represent future un- collateralized borrowing between banks. Treasuries should be expensive and produce yields that are lower than those of maturity matched swap rates, as they are deemed to have supe- rior liquidity and to be safe, so this is a surprising development. We show, by no-arbitrage, that the U.S. sovereign default risk explains the negative swap spreads over Treasuries. This view is supported by a quantitative equilibrium model that jointly accounts for macroeco- nomic fundamentals and the term structures of interest and U.S. credit default swap rates. We account for interbank credit risk, liquidity effects, and cost of collateralization in the model. Thus, the sovereign risk explanation complements others based on frictions such as balance sheet constraints, convenience yield, and hedging demand.
Keywords: Sovereign Credit Risk; Negative Swap Rates; Recursive Preferences; Term Structure
JEL Codes: C1; E43; E44; G12; H60
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| US sovereign default risk (H63) | negative swap spreads (G12) |
| perceived credit risk of the US government (F34) | pricing of swaps versus treasuries (E43) |
| US sovereign credit risk (F34) | swap contract value relative to credit-risky treasury bond (G12) |
| US credit risk (F34) | swap spreads remain positive (F31) |