Working Paper: NBER ID: w25422
Authors: Urban Jermann
Abstract: Since October 2008 fixed rates for interest rate swaps with a thirty year maturity have been mostly below treasury rates with the same maturity. Under standard assumptions this implies the existence of arbitrage opportunities. This paper presents a model for pricing interest rate swaps where frictions for holding bonds limit arbitrage. I show analytically that negative swap spreads should not be surprising. In the calibrated model, swap spreads can reasonably match empirical counterparts without the need for large demand imbalances in the swap market. Empirical evidence is consistent with the relation between term spreads and swap spreads in the model
Keywords: swap spread; limited arbitrage; fixed income arbitrage
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited arbitrage conditions (D41) | negative swap spreads (G12) |
| holding costs (G31) | negative swap spreads (G12) |
| regulatory changes (G18) | costs of holding government bonds (E43) |
| costs of holding government bonds (E43) | capacity to engage in arbitrage (G19) |
| capacity to engage in arbitrage (G19) | negative swap spreads (G12) |
| term spreads (G10) | swap spreads (F31) |