Trading risk, market liquidity, and convergence trading in the interest rate swap spread

While trading activity is generally thought to play a central role in the self-stabilizing behavior of markets, the risks in trading on occasion can affect market liquidity and heighten asset price volatility. This article examines empirical evidence on the limits of arbitrage in the interest rate swap market. The author finds both stabilizing and destabilizing forces attributable to leveraged trading activity. Although the swap spread tends to converge to its fundamental level, it does so more slowly or even diverges from its fundamental level when traders are under stress, as indicated by shocks in hedge fund earnings and the volume of repo contracts. In addition, repo volume falls when convergence trading risk is higher, and reflects shocks that destabilize the swap spread. The behavior of repo volume in particular points to how trading risk affects market liquidity and asset price volatility.