Modeling Swap Spreads in Normal and Stressed Environments

Abstract

We develop a simple integrated model for the term structure of swap spreads. We begin with a model that explains the dynamics of the riskless treasury curve in terms of two factors. We add to the basic model additional inputs that describe the evolution of the implied hazard rate intensity for interest rate swaps. Based on the model, we derive closed form expressions for observables such as the shape of the term structure of swap spreads and the term structure of volatilities. Our model is economically motivated, and is appealing in its simplicity and robustness in being able to explain the dynamics of the swap spread term structure in both normal and stressed markets. We apply the technique to swap-spread term structures for various international markets.