Modeling Money Market Spreads: What Do We Learn About Refinancing Risk?

48 Pages Posted: 4 Jan 2015 Last revised: 25 Aug 2015

See all articles by Vincent Brousseau

Vincent Brousseau

European Central Bank, Directorate General Economics

Kleopatra Nikolaou

Federal Reserve Board of Governors

Huw Pill

Goldman Sachs, Australia

Multiple version iconThere are 2 versions of this paper

Date Written: December 29, 2014

Abstract

We quantify the effect of refinancing risk on euro area money market spreads, a major factor driving spreads during the financing crisis. With the advent of the crisis, market participants' perception of their ability to refinance over a given period of time changed radically. As a result, borrowers preferred to obtain funding for longer tenors and lenders were willing to provide funding for shorter tenors. This discrepancy resulted in a need to refinance more frequently in order to borrow over a given horizon, thus increasing refinancing risk. We measure refinancing risk by quantifying the sensitivity of the spread to the refinancing frequency. In order to do so we introduce a model to price EURIBOR-based money market spreads vis-à-vis the overnight index swap. We adopt a methodology akin to a factor model in which the parameters determining the spreads are the intensity of the crisis, its expected half-life, and the sensitivity of spreads to the refinancing frequency. Results suggest that refinancing risk affects the spread significantly across time, albeit in a largely varying manner. Central bank interventions have reduced the spreads as well as the effect of refinancing risk on them.

Keywords: financial crisis, liquidity risk, money market spread, money markets, refinancing risk

JEL Classification: E58, G12, G21

Suggested Citation

Brousseau, Vincent and Nikolaou, Kleopatra and Pill, Huw, Modeling Money Market Spreads: What Do We Learn About Refinancing Risk? (December 29, 2014). FEDS Working Paper No. 2014-112, Available at SSRN: https://ssrn.com/abstract=2544689 or http://dx.doi.org/10.2139/ssrn.2544689

Vincent Brousseau

European Central Bank, Directorate General Economics ( email )

Kaiserstrasse 29
Frankfurt am Main, 60311
Germany
0049 69 13440 (Phone)
0044 69 1344 6000 (Fax)

Kleopatra Nikolaou (Contact Author)

Federal Reserve Board of Governors ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Huw Pill

Goldman Sachs, Australia ( email )

1 Farrer Place
Sydney, NSW 2000
Australia

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