Working Paper: NBER ID: w26429
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 uncollateralized 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 superior 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 macroeconomic 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: Interest rates; Sovereign risk; Credit default swaps; Financial crisis
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 |
|---|---|
| Perceived credit quality of the US government (H63) | Benchmark interest rates (E43) |
| US sovereign default risk (H63) | Negative swap spreads (G19) |
| Changes in perceived credit risk (G21) | Fluctuations in swap spreads (E43) |
| Credit default swaps (CDS) (G33) | Modification of expected cash flows from treasury bonds (E43) |
| Negative swap spreads (G19) | Role of CDS premiums (G22) |