The Market for Sharing Interest Rate Risk: Quantities and Asset Prices

Abstract

We study interest rate risk sharing across the financial system using novel data on cross-sector interest rate swap positions. We show that pension funds and insurers (PF&I) are natural counterparties to banks and corporations: PF&I buy duration, whereas banks and corporations sell duration. However, demand is highly segmented across maturities, resulting in significant imbalances at various maturity points. We calibrate a preferred-habitat investors model with risk-averse arbitrageurs to study how demand imbalances interact with supply side constraints to impact swap spreads. Our framework helps quantify the spillover effects of demand shifts, which informs policy discussions on financial institutions’ hedging requirements.

Keywords: Interest rate risk, Pension funds, Insurers, Banks, Corporations, Demand elasticities, Swap spreads

JEL Classification: G11, G12, G15, G21, G22, G23, G24, G32