Modeling Money Market Spreads : What Do We Learn About Refinancing Risk?

We quantify the effect of refinancing risk on euro area money market spreads, a major factor driving spreads during the financing crisis. With the advent of the crisis, market participants' perception of their ability to refinance over a certain period of time changed radically. As a result, borrowers preferred to obtain funding for longer tenors and lenders were willing to provide funding for shorter tenors. This discrepancy resulted in a need to refinance more frequently in order to borrow over a given horizon, thus increasing refinancing risk. We measure refinancing risk by quantifying the sensitivity of the spread to the refinancing frequency. In order to do so we introduce a model to price EURIBOR-based money market spreads vis-à-vis the overnight index swap. We adopt a methodology akin to a factor model in which the parameters determining the spreads are the intensity of the crisis, its expected duration, and the sensitivity of spreads to the refinancing frequency. Results suggest that refinancing risk affects the spread significantly across time, albeit at a largely varying manner. Central bank interventions have reduced the spreads as well as the effect of refinancing risk on them