Determinants of interest rate swap spreads |
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Authors: | Larry H P Lang Robert H Litzenberger Andy Luchuan Liu |
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Institution: | aChinese University of Hong Kong, Hong Kong, People's Republic of China;bUniversity of Chicago, Chicago, IL USA;cWharton School, University of Pennsylvania, Philadelphia, PA, USA and Goldman Sachs and Company;dFaculty of Business, City University of Hong Kong, Tatchee Avenue, Kowloon, Hong Kong, People's Republic of China |
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Abstract: | This study argues that an interest rate swap, as a non-redundant security, creates surplus which will be shared by swap counterparties to compensate their risks in swaps. This action in turns affects swap spreads. Analyzing the time series impacts of the changes of risks of swap counterparties on swap spreads, we conclude that both lower and higher rating bond spreads have positive impacts on swap spreads. We also derive a risk–spread relation to test if swap counterparties are firms with differential credit ratings. Since the risk allocation between swap counterparties varies over business cycles, hence this factor needs to be controlled. We conclude that (1) similar results hold if the business cycle factor is controlled and (2) swap spreads contain procyclical element and are less cyclical than lower credit rating bond spreads. |
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Keywords: | Interest rate swap Swap spread Financing strategy Bond Derivatives |
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