Default Risk and Innovations in the Design of Interest Rate Swaps

Using data from the Treasury versus London Interbank Offer Swap Rates (LIBOR) for October 1987 to June 1998, this paper examines the determinants of swap spreads in the Treasury-LIBOR interest rate swap market. This study hypothesizes Treasury-LIBOR swap spreads as a function of the Treasury rate of comparable maturity, the slope of the yield curve, the volatility of short-term interest rates, a proxy for default risk, and liquidity in the swap market. The study finds that, in the long-run, swap spreads are negatively related to the yield curve slope and liquidity in the swap market. We also find that swap spreads are positively related to the short-term interest rate volatility. In the short-run, swap market's response to higher default risk seems to be higher spread between the bid and offer rates.

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Between Scylla and Charybdis: The Bermudan Swaptions Pricing Odyssey

Mathematics ◽

10.3390/math9020112 ◽

2021 ◽

Vol 9 (2) ◽

pp. 112

Author(s):

Dariusz Gatarek ◽

Juliusz Jabłecki

Keyword(s):

Interest Rate ◽

One Dimensional ◽

Classic Result ◽

Implementation Techniques ◽

Interest Rate Swaps ◽

Exercise Boundary ◽

Bermudan Swaptions ◽

Main Ideas ◽

Multidimensional Process ◽

Theoretical Side

Bermudan swaptions are options on interest rate swaps which can be exercised on one or more dates before the final maturity of the swap. Because the exercise boundary between the continuation area and stopping area is inherently complex and multi-dimensional for interest rate products, there is an inherent “tug of war” between the pursuit of calibration and pricing precision, tractability, and implementation efficiency. After reviewing the main ideas and implementation techniques underlying both single- and multi-factor models, we offer our own approach based on dimension reduction via Markovian projection. Specifically, on the theoretical side, we provide a reinterpretation and extension of the classic result due to Gyöngy which covers non-probabilistic, discounted, distributions relevant in option pricing. Thus, we show that for purposes of swaption pricing, a potentially complex and multidimensional process for the underlying swap rate can be collapsed to a one-dimensional one. The empirical contribution of the paper consists in demonstrating that even though we only match the marginal distributions of the two processes, Bermudan swaptions prices calculated using such an approach appear well-behaved and closely aligned to counterparts from more sophisticated models.

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Pricing Interest Rate Swaps in Malaysia

Review of Pacific Basin Financial Markets and Policies ◽

10.1142/s0219091504000251 ◽

2004 ◽

Vol 07 (04) ◽

pp. 493-507 ◽

Cited By ~ 2

Author(s):

Dick Davies ◽

David Hillier ◽

Andrew Marshall ◽

King Fui Cheah

Keyword(s):

Interest Rate ◽

Yield Curve ◽

Capital Controls ◽

Sample Period ◽

Kuala Lumpur ◽

Empirical Results ◽

Illiquid Markets ◽

Interest Rate Swaps ◽

Derivative Markets

This paper compares the theoretical price of interest rate swaps implied from the yield curve with the actual Kuala Lumpur Interbank Offer Rates used for swap resets in the Malaysian swap market for both semi-annual and annual interest rate swaps between 1996 and 2002. As far as we are aware no previous paper has considered pricing swaps in a less established derivative markets. Our empirical results indicate significant and persistent differences between the theoretical implied price and the actual reset price for both swaps over the sample period. This finding has implications for traders and banks in pricing swaps in Malaysia and more generally for pricing swaps in less established or illiquid markets or where capital controls have been introduced.

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