A vector-autoregression analysis of credit and liquidity factor dynamics in US LIBOR and Euribor swap markets |
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Authors: | Finbarr Murphy Bernard Murphy |
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Institution: | (1) University of Limerick, Limerick, Ireland |
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Abstract: | We use a vector autoregressive approach to investigate the determinants of US Dollar LIBOR and Euribor swap spread variation
during the 2007–2009 crisis in global credit and money markets. Using market-quoted yield and spread data from the highly
liquid credit default swap (CDS) and overnight index swap (OIS) markets, we provide compelling empirical evidence that liquidity
risk factor shocks have been the dominant drivers of the variation in swap spreads over this period. Our findings provide
an explanation for the temporal differences that liquidity shocks have on swap spreads and provide a contemporary perspective
on the dynamical interplay between credit-default and liquidity risk-factors in these markets. As all our risk-factor proxies
are traded in liquid derivatives markets, our findings have implications for proprietary hedge fund traders hedging an exposure
to swap-spread risk, for bank treasurers managing their liquidity requirements and for central bankers seeking to better understand
the response of markets to their macroeconomic policy implementation and liquidity management actions. Indeed our markets-based
analysis suggests that the European Central Bank (ECB) has underperformed relative to the Federal Reserve in terms of the
differing levels of market confidence placed in its macroeconomic policy actions and remedial liquidity interventions during
the period. |
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