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Title: Benchmark interest rates when the government is risky

Author(s): Patrick Augustin, Mikhail Chernov, Lukas Schmid and Dongo Song

Publication Date: November 2019

Keyword(s): negative swap rates, recursive preferences, sovereign credit risk and term structure

Programme Area(s): Financial Economics

Abstract: Since the Global Financial Crisis, rates on interest rate swaps have fallen below maturity matched U.S. Treasury rates across different maturities. Swap rates represent future un- collateralized borrowing between banks. Treasuries should be expensive and produce yields that are lower than those of maturity matched swap rates, as they are deemed to have supe- rior liquidity and to be safe, so this is a surprising development. We show, by no-arbitrage, that the U.S. sovereign default risk explains the negative swap spreads over Treasuries. This view is supported by a quantitative equilibrium model that jointly accounts for macroeco- nomic fundamentals and the term structures of interest and U.S. credit default swap rates. We account for interbank credit risk, liquidity effects, and cost of collateralization in the model. Thus, the sovereign risk explanation complements others based on frictions such as balance sheet constraints, convenience yield, and hedging demand.

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Bibliographic Reference

Augustin, P, Chernov, M, Schmid, L and Song, D. 2019. 'Benchmark interest rates when the government is risky'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14105