Benchmark Interest Rates When the Government is Risky

72 Pages Posted: 6 Nov 2019

See all articles by Patrick Augustin

Patrick Augustin

McGill University, Desautels Faculty of Management

Mikhail Chernov

UCLA Anderson

Lukas Schmid

University of Southern California - Marshall School of Business

Dongho Song

Johns Hopkins University - Carey Business School

Multiple version iconThere are 2 versions of this paper

Date Written: November 2019

Abstract

Since the Global Financial Crisis, rates on interest rate swaps have fallen below maturity matched U.S. Treasury rates across different maturities. Swap rates represent future uncollateralized borrowing between banks. Treasuries should be expensive and produce yields that are lower than those of maturity matched swap rates, as they are deemed to have superior liquidity and to be safe, so this is a surprising development. We show, by no-arbitrage, that the U.S. sovereign default risk explains the negative swap spreads over Treasuries. This view is supported by a quantitative equilibrium model that jointly accounts for macroeconomic fundamentals and the term structures of interest and U.S. credit default swap rates. We account for interbank credit risk, liquidity effects, and cost of collateralization in the model. Thus, the sovereign risk explanation complements others based on frictions such as balance sheet constraints, convenience yield, and hedging demand.

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Suggested Citation

Augustin, Patrick and Chernov, Mikhail and Schmid, Lukas and Song, Dongho, Benchmark Interest Rates When the Government is Risky (November 2019). NBER Working Paper No. w26429, Available at SSRN: https://ssrn.com/abstract=3480299

Patrick Augustin (Contact Author)

McGill University, Desautels Faculty of Management ( email )

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Mikhail Chernov

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
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Lukas Schmid

University of Southern California - Marshall School of Business ( email )

701 Exposition Blvd, HOH 431
Los Angeles, CA California 90089-1424
United States

Dongho Song

Johns Hopkins University - Carey Business School ( email )

Baltimore, MD 20036-1984
United States

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