Modeling the Determinants of Swap Spreads

Abstract

The authors use a multivariate exponential generalized autoregressive conditional heteroscedasticity (EGARCH) model to investigate the determinants of interest rate swap spreads in Australia. They find that changes in the spread are negatively related to changes in the level of default-free interest rates and to changes in the slope of the term structure. The curvature factor of the term structure is found to be a poor proxy in explaining changes in the spread. There is a strong and significant volatility interaction among spreads for swaps of different terms to maturity. The process for the conditional variance of the spread is highly persistent across all maturities. Credit risk but not swap market liquidity is also an important source of variation in Australian swap spreads.