Working Paper: NBER ID: w8990
Authors: Jun Liu; Francis A. Longstaff; Ravit E. Mandell
Abstract: This paper studies the market price of credit risk incorporated into one of the most important credit spreads in the financial markets: interest rate swap spreads. Our approach consists of jointly modeling the swap and Treasury term structures using a general five-factor affine credit framework and estimating the parameters by maximum likelihood. We solve for the implied special financing rate for Treasury bonds and find that the liquidity component of on-the-run bond prices can be significant. We also find that credit premia in swap spreads are positive on average. These premia, however, vary significantly over time and were actually negative for much of the 1990s.
Keywords: credit risk; interest rate swaps; swap spreads; liquidity
JEL Codes: E4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| credit risk (G21) | swap spreads (F31) |
| liquidity (E41) | swap spreads (F31) |
| credit risk and liquidity risk (G33) | swap spreads (F31) |
| liquidity (E41) | pricing of interest rate swap spreads (E43) |
| swap spreads (F31) | credit premia (G21) |
| changes in liquidity (E41) | credit premia (G21) |
| perceived default risk (G33) | credit premia (G21) |
| implied riskless rate (E43) | treasury bill rate (E43) |