DETERMINANTS OF INTEREST-RATE SWAP SPREADS

This study argues that an interest rate swap, as a non-redundant secur ity, creates surplus which will be shared by swap counterparties to co mpensate their risks in swaps. This action in turns affects swap sprea ds. Analyzing the time series impacts of the changes of risks of swap counterparties on swap spreads, we conclude that both lower and higher rating bond spreads have positive impacts on swap spreads, We also de rive a risk-spread relation to test if swap counterparties are firms w ith differential credit ratings. Since the risk allocation between swa p counterparties varies over business cycles, hence this factor needs to be controlled. We conclude that (1) similar results hold if the bus iness cycle factor is controlled and (2) swap spreads contain procycli cal element and are less cyclical than lower credit rating bond spread s. (C) 1998 Elsevier Science B.V. All rights reserved.