The Market Price of Credit Risk: An Empirical Analysis of Interest Rate Swap Spreads
Jun Liu, Francis A. Longstaff, Ravit E. Mandell
NBER Working Paper No. 8990
This paper studies the market price of credit risk incorporated into one of the most important credit spreads in the financial markets: interest rate swap spreads. Our approach consists of jointly modeling the swap and Treasury term structures using a general five-factor affine credit framework and estimating the parameters by maximum likelihood. We solve for the implied special financing rate for Treasury bonds and find that the liquidity component of on-the-run bond prices can be significant. We also find that credit premia in swap spreads are positive on average. These premia, however, vary significantly over time and were actually negative for much of the 1990s.
Published: Liu, Jun, Francis A. Longstaff, and Ravit Mandell. "The Market Price of Risk in Interest Rate Swaps: The Roles of Default and Liquidity Risks." The Journal of Business 79, 5 (September 2006): 2337-2360.