Interest Rate Swaps: An Asset Allocation Perspective

Boston College Carroll School of Management Working Paper

33 Pages Posted: 11 Mar 2002

See all articles by George O. Aragon

George O. Aragon

Arizona State University (ASU) - Finance Department

Date Written: April 24, 2002

Abstract

This paper investigates the asset allocation benefits of the interest rate swap market. I use 'convexity-adjusted' Eurodollar futures data to compute monthly holding period 'returns' from positions in the swap market. Spanning test methodology is employed to determine whether, after accounting for short sales constraints and bid-ask spreads, positions in the swap market add value to a well-diversified bond portfolio. I find evidence suggesting both long and short positions in the interest rate swap market (IRS) provide significant value improvements for a mean-variance investor. Moreover, while the value of the IRS market for 'unrestricted' investment in the bond market has disappeared as the IRS market has evolved, long IRS positions remain valuable for investors subject to short sales constraints. Most of these results do not depend on either swap maturity or the specific market conventions used to compute swap sale values. Thus, investors may expect to realize these benefits independent of market frictions and dealer-related idiosyncracies.

Keywords: Swaps, convexity bias, Eurodollar futures, spanning

JEL Classification: G12, G13

Suggested Citation

Aragon, George O., Interest Rate Swaps: An Asset Allocation Perspective (April 24, 2002). Boston College Carroll School of Management Working Paper, Available at SSRN: https://ssrn.com/abstract=302012 or http://dx.doi.org/10.2139/ssrn.302012

George O. Aragon (Contact Author)

Arizona State University (ASU) - Finance Department ( email )

W. P. Carey School of Business
PO Box 873906
Tempe, AZ 85287-3906
United States

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