Common risk factors in the U.S. and UK interest rate swap markets: Evidence from a nonlinear vector autoregression approach

Abstract

This paper produces evidence in support of the existence of common risk factors in the U.S. and UK interest rate swap markets. Using a multivariate smooth transition autoregression (STVAR) framework, we show that the dynamics of the U.S. and UK swap spreads are best described by a regime-switching model. We identify the existence of two distinct regimesWe would like to thank Robert Webb (the Editor) and a referee of this journal for very useful comments and suggestions. We have also benefited from the comments of Dick Van Dijk (who has provided us with nonlinear routines in Gauss), Mike Clements, Gary Koop, Chris Martin, Lucio Sarno, and Giorgio Valente. Any remaining errors are ours. *Correspondence author, Department of Economics, City University, Northampton Square, London EC1V OHB, UK; e-mail: c.milas@city.ac.uk Received October 2002; Accepted April 2003 I Ilias Lekkos is in the Credit Risk Management Division at Halifax-Bank of Scotland Treasury Services in London, United Kingdom I Costas Milas is a Senior Lecturer in the Department of Economics at City University in the United Kingdom 222Lekkos and Milas in U.S. and UK swap spreads; one is characterized by a "flat" term structure of U.S. interest rates and the other is characterized by an "upward" sloping U.S. term structure. In addition, we show that there exist significant asymmetries on the impact of the common risk factors on the U.S. and UK swap spreads. Shocks to UK oriented risk factors have a strong effect on the U.S. swap markets during the "flat" slope regime but a very limited effect otherwise. On the other hand, U.S. risk factors have a significant impact on the UK swap markets in both regimes.

Determinants of Japanese Yen interest rate swap spreads: Evidence from a smooth transition vector autoregressive model

“…That is, the magnitude of the response of SS5 to the default shock is twice that of SS2. This is similar to the findings in other studies (e.g., Lekkos & Milas, 2004). This result stems from the fact that the exposure to the possibility of default (from the floating-rate…”

“…In this section, the VAR extension of the STVAR model in Camacho (2004) is considered, which is also employed in Milas (2004), andMilas et al (2007). The model permits a smooth transition of regimes based upon an empirically chosen economic factor.…”

“…Suhonen (1998) and Milas (2001) study interest rate swaps using both U.S. and U.K. data. Lekkos and Milas (2004) model U.S. and U.K. swap spreads within an STVAR framework allowing for steep or flat yield curve slopes. Fang and Muljono (2003) investigate Australian dollar interest rate swaps and conclude that the spreads mostly represent a credit risk premium.…”

“…Importantly, the majority of the swap rate studies rely upon ordinary least squares (OLS) and linear VAR analyses. Nonlinear models in recent years have been proven to outperform the linear ones, such as Lekkos and Milas (2004) and Milas, Lekkos, and Panagiotidis (2007), which find interpretation of the results more flexible and provide better predictive power on swap spreads.…”

Forecasting interest rate swap spreads using domestic and international risk factors: evidence from linear and non‐linear models

“…More recently, Lekkos and Milas (2004) and examined in detail the issue of international linkages between interest rate swap markets.…”