THE MARKET PRICE OF RISK IN INTEREST RATE SWAPS: THE ROLES OF DEFAULT AND LIQUIDITY RISKS

We study how the market prices the default and liquidity risks incorporated into one of the most important credit spreads in the financial markets–interest rate swap spreads. Our approach consists of jointly modeling the Treasury, repo, and swap term structures using a general five-factor affine credit framework and estimating the parameters by maximum likelihood. We find that the credit spread is driven by changes in a persistent liquidity process and a rapidly mean-reverting default intensity process. Although both processes have similar volatilities, we find that the credit premium priced into swap rates is primarily compensation for liquidity risk. The term structure of liquidity premia increases steeply with maturity. In contrast, the term structure of default premia is almost flat. However, both liquidity and default premia vary significantly over time.