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

This paper produces evidence in support of the existence of common risk factors in the US andUK 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 aregime-switching model. We identify the existence of two distinct regimes in US and UK swapspreads; one characterized by a "flat" term structure of US interest rates and the othercharacterized by an "upward" slopping US term structure. In addition, we show that there existsignificant asymmetries on the impact of the common risk factors on the US and UK swapspreads. Shocks to UK oriented risk factors have a strong effect on the US swap markets duringthe "flat" slope regime but a very limited effect otherwise. On the other hand, US risk factorshave a significant impact on the UK swap markets in both regimes. Despite their addedflexibility, the STVAR models do not consistently produce superior forecasts compared to lesssophisticated autoregressive (AR) and vector autoregressive (VAR) models.