Benchmark Interest Rates When the Government is Risky

74 Pages Posted: 15 Nov 2019 Last revised: 2 Dec 2019

See all articles by Patrick Augustin

Patrick Augustin

McGill University, Desautels Faculty of Management

Mikhail Chernov

UCLA Anderson

Lukas Schmid

Duke University - The Fuqua 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 un- collateralized 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 supe- rior 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 macroeco- nomic 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.

Keywords: negative swap rates, recursive preferences, sovereign credit risk, term structure

JEL Classification: C1, E43, E44, G12, H60

Suggested Citation

Augustin, Patrick and Chernov, Mikhail and Schmid, Lukas and Song, Dongho, Benchmark Interest Rates When the Government is Risky (November 2019). CEPR Discussion Paper No. DP14105. Available at SSRN: https://ssrn.com/abstract=3486256

Patrick Augustin (Contact Author)

McGill University, Desautels Faculty of Management ( email )

1001 Sherbrooke Street West
Quebec
Montreal, Quebec H3A 1G5
Canada

HOME PAGE: http://www.patrickaugustin.se

Mikhail Chernov

UCLA Anderson ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Lukas Schmid

Duke University - The Fuqua School of Business ( email )

Durham, NC 27708-0120
United States

Dongho Song

Johns Hopkins University - Carey Business School ( email )

Baltimore, MD 20036-1984
United States

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