The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads

44 Pages Posted: 13 Oct 2001

See all articles by Francis A. Longstaff

Francis A. Longstaff

University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Ravit E. Mandell

Salomon Smith Barney, Inc., U.S.

Multiple version iconThere are 2 versions of this paper

Date Written: October 2000

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 four-factor ane 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 very significant. We show that most of the variation in swap spreads is driven by changes in the liquidity of Treasury bonds rather than changes in default risk. We find that there are positive credit premia in swap spreads on average. These premia, however, vary significantly over time and were negative for much of the 1990s. Since the hedge-fund crisis of 1998, credit premia have become positive and are currently at historical high.

Suggested Citation

Longstaff, Francis A. and Liu, Jun and Mandell, Ravit E., The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads (October 2000). AFA 2002 Atlanta Meetings. Available at SSRN: https://ssrn.com/abstract=287101 or http://dx.doi.org/10.2139/ssrn.287101

Francis A. Longstaff (Contact Author)

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-2218 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

Ravit E. Mandell

Salomon Smith Barney, Inc., U.S.

New York, NY 10013
United States

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