The International Linkage of Interest Rate Swap Spreads: The Yen-Dollar Markets

Abstract

In this paper, we investigate Japanese yen and U.S. dollar interest rate swap markets during the period 1990-99. We measure the spreads of the swap rates over comparable treasury yields (on Japanese Government Bonds (JGBs) and U.S. Treasury bonds, respectively) for different maturities. We then analyze the relationship between the swap spreads in the two markets.

Our main empirical results are that: (1) the correlations between yen and dollar interest swap spreads are low, indicating that the credit risk factor is country-specific, rather than global in nature, (2) dollar interest rate swaps "Granger-cause" the changes in the spreads of yen interest rate swaps for the long (ten-year) maturities, but the causality does not run the other way, and (3) yen swap spreads are highly correlated with the interest rate differentials between the two markets, and the interest rate differentials have a significant impact on subsequent movements in the yen swap spreads. These empirical results indicate that the specific institutional aspects of the yen fixed income market, such as illiquidity and market frictions, may have affected the yen interest swap rate and the swap spread.

Keywords: interest rate swaps, interest rate swap spreads, relative value, international linkages, credit risk

JEL Classification: G12, G13, G15