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Decomposing Swap Spreads

by Peter Feldhütter of the Copenhagen Business School, and
David Lando of the Copenhagen Business School & Princeton University

February 20, 2008

Abstract: We analyze a six-factor model for Treasury bonds, corporate bonds, and swap rates and decompose swap spreads into three components: a convenience yield from holding Treasuries, a credit risk element from the underlying LIBOR rate, and a factor specific to the swap market. The convenience yield is by far the largest component of spreads. There is a discernible contribution from credit risk as well as from a swap-specific factor with higher variability which in certain periods is related to hedging activity in the mortgage-backed security market. The model also sheds light on the relation between AA hazard rates and the spread between LIBOR rates and General Collateral repo rates and on the level of the riskless rate compared to swap and Treasury rates.

JEL Classification: G12, G13, G21.

Keywords: Swap yields, term structure of interest rates, credit spreads.

Published in: Journal of Financial Economics, Vol. 88, No. 2, (May 2008), pp. 375-405.

Previously titled: "A Model for Corporate Bonds, Swaps and Treasury Securities" --and-- "A Model of Swap Spreads and Corporate Bond Yields"

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