Negative Swap Spreads and Limited Arbitrage
NBER Working Paper No. 25422
Since October 2008 fixed rates for interest rate swaps with a thirty year maturity have been mostly below treasury rates with the same maturity. Under standard assumptions this implies the existence of arbitrage opportunities. This paper presents a model for pricing interest rate swaps where frictions for holding bonds limit arbitrage. I show analytically that negative swap spreads should not be surprising. In the calibrated model, swap spreads can reasonably match empirical counterparts without the need for large demand imbalances in the swap market. Empirical evidence is consistent with the relation between term spreads and swap spreads in the model
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Document Object Identifier (DOI): 10.3386/w25422
Published: Urban J Jermann, 2020. "Negative Swap Spreads and Limited Arbitrage," The Review of Financial Studies, vol 33(1), pages 212-238.