Negative Swap Spreads and Limited Arbitrage
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
Comments from seminar and conference participants at Wharton, NYU Stern, Michigan Ross, the Federal Reserve Board, the NBER Asset Pricing Summer Institute, Minnesota Carlson and the University of Chicago, as well as from Itamar Drechsler, Marti Subrahmanyam, Min Wei, Hiroatsu Tanaka, Andrea Eisfeldt, Francis Longstaff, Frederico Belo and Tim Landvoigt are gratefully acknowledged. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.