Modeling Term Structures of Swap Spreads∗

Swap spreads, the interest rate differentials between the fixed rates on fixed-for-floating swap contracts and the yields-to-maturity on maturity-matched government bonds, define a market for one of the most actively transacted securities in the global fixed-income arena. A large universe of fixed-income securities including corporate bonds and mortgaged-back securities use interest rate swap spreads as a key benchmark for pricing and hedging. Swap spreads have received renewed attention since the Fall of 1998 when their volatile movements contributed in a significant way to the financial turmoil that led the US Fed to cut short-term interest rates by 75 basis points. In this paper we present new insights on how to analyze term structure of interest swap spreads. Specifically, we focus on the determinants of swap spreads and show how quantities such as the spread of short-term LIBOR over GC-repo rates, the liquidity premium commended by government bonds, and the risk premium required for holding long-term bonds/swaps jointly determine term structures of swap spreads. ∗The author thanks seminar participants at UT Austin, Wharton, Yale, Federal Reserve Board, and the Financial Engineering Workshop at U. of Chicago for helpful comments, and thanks Lehman Brothers for providing the data. Support from the International Center for Finance at Yale School of Management is gratefully acknowledged.