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Common risk factors in the US and UK interest rate swap markets:Evidence from a non-linear vector autoregression approach

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  • Ilias Lekkos
  • Costas Milas

Abstract

This paper produces evidence in support of the existence of common risk factors in the US and UK interest rate swap markets. Using a multivariate smooth transition autoregression (STVAR) framework, we show that the dynamics of the US and UK swap spreads are best described by a regime-switching model. We identify the existence of two distinct regimes in US and UK swap spreads; one characterized by a "flat" term structure of US interest rates and the other characterized by an "upward" slopping US term structure. In addition, we show that there exist significant asymmetries on the impact of the common risk factors on the US and UK swap spreads. Shocks to UK oriented risk factors have a strong effect on the US swap markets during the "flat" slope regime but a very limited effect otherwise. On the other hand, US risk factors have a significant impact on the UK swap markets in both regimes. Despite their added flexibility, the STVAR models do not consistently produce superior forecasts compared to less sophisticated autoregressive (AR) and vector autoregressive (VAR) models.

Suggested Citation

  • Ilias Lekkos & Costas Milas, 2002. "Common risk factors in the US and UK interest rate swap markets:Evidence from a non-linear vector autoregression approach," Economics and Finance Discussion Papers 02-05, Economics and Finance Section, School of Social Sciences, Brunel University.
    • Handle: RePEc:bru:bruedp:02-05
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    Cited by:

    1. Kenneth A. Tah, 2022. "Determinants of Interest rate swap spreads: A quantile regression approach," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 46(3), pages 522-534, July.
    2. Li, Shaoyu & Zhu, Chunhui & Shang, Yuhuang, 2023. "Hedging demand and near-zero swap spreads: Evidence from the Chinese interest rate swap market," The Quarterly Review of Economics and Finance, Elsevier, vol. 91(C), pages 170-185.
    3. Ilias Lekkos & Costas Milas & Theodore Panagiotidis, 2007. "Forecasting interest rate swap spreads using domestic and international risk factors: evidence from linear and non-linear models," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 26(8), pages 601-619.
    4. Nechi, Salem & Smaoui, Houcem Eddine, 2019. "Interbank offered rates in Islamic countries: Is the Islamic benchmark different from the conventional benchmarks?," The Quarterly Review of Economics and Finance, Elsevier, vol. 74(C), pages 75-84.
    5. Ying Huang & Carl R. Chen, 2007. "The effect of Fed monetary policy regimes on the US interest rate swap spreads," Review of Financial Economics, John Wiley & Sons, vol. 16(4), pages 375-399.
    6. Sohel Azad, A.S.M. & Batten, Jonathan A. & Fang, Victor & Wickramanayake, Jayasinghe, 2015. "International swap market contagion and volatility," Economic Modelling, Elsevier, vol. 47(C), pages 355-371.

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