The Transmission of Swap Spreads and Volatilities in the International Swap Markets

Abstract

We investigate the Japanese yen and U.S. dollar interest rate swap markets during the period 1990-2000, by examining 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 transmission of shocks in the swap spreads and their volatilities from one market to the other.

Our main findings are: (1) the correlations between the yen and dollar interest swap spreads are low, indicating that the credit risk factor is country-specific, rather than global in nature, (2) the changes in the dollar interest rate swap spreads "Granger-cause" the changes in the spreads of yen interest rate swaps for the long (10-year) maturities, but the causality does not run the other way, (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, (4) the transmission of the volatility of swap spreads is strong from the dollar to the yen markets and relatively weak in the other direction, and (5) shocks to the dollar swap spread have an asymmetric impact on the volatilities of the spreads in both the yen and dollar swap markets, i.e., an increase in the dollar swap spread leads to higher future volatility of the spreads in both swap markets, but a decrease does not. These empirical results suggest that specific institutional aspects, such as illiquidity and market frictions, may have affected the yen interest swap market more than its dollar counterpart.

Keywords: Interest Rate Swaps, Interest Rate Swap Spreads, Volatility of Swap Spreads, Credit Risk, Transmission of Swap Spreads

JEL Classification: G12, G13, G15