Article2019

Negative Swap Spreads and Limited Arbitrage

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Stochastic processes and financial applications Financial Markets and Investment Strategies Credit Risk and Financial Regulations

Abstract

Abstract Since October 2008, fixed rates for interest rate swaps with a 30-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 analytically show 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. Received April 16, 2017; editorial decision Januray 3, 2019 by Editor Stijn Van Nieuwerburgh.

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References

1995The Limits of Arbitrage 2002Closing Small Open Economy Models 1998Agency Costs, Risk Management, and Capital Structure 1991Real Business Cycles in a Small Open Economy 2005Demand-Based Option Pricing 2018Deviations from Covered Interest Rate Parity 1992Projection methods for solving aggregate growth models 2010Limits of Arbitrage

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