The Market Price of Risk in Interest Rate Swaps: The roles of default and liquidity risks

by Jun Liu of the University of California, San Diego,
Francis A. Longstaff of the University of California, Los Angeles, and
Ravit E. Mandell of Citigroup

September 2006

Abstract: We study how the market prices the default and liquidity risks incorporated into interest rate swap spreads. We jointly model the Treasury, repo, and swap term structures using a five-factor affine framework and estimate the model by maximum likelihood. The credit spread is driven by a persistent liquidity process and a rapidly mean-reverting default intensity process. The credit premium for all but the shortest maturities is primarily compensation for liquidity risk. The term structure of liquidity premia increases steeply, while that of default premia is almost flat. Both liquidity and default premia vary significantly over time.

Published in: Journal of Business, Vol. 79, No. 5, (September 2006), pp. 2337-2359.

Previously titled: The Market Price of Credit Risk: An empirical analysis of interest rate swap spreads

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