Common Risk Factors in the Us and UK Interest Rate Swap Markets: Evidence from a Non-Linear Vector Autoregression Approach

Brunel University Working Paper

36 Pages Posted: 27 Feb 2002

See all articles by Costas Milas

Costas Milas

Keele University; Brunel University London - Economics and Finance

Ilias Lekkos

Bank of England

Date Written: February 2002

Abstract

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

Keywords: Interest rate swaps, swap spreads, term structure of interest rates, regime switching, smooth transition models

JEL Classification: C51, C52, C53, E43

Suggested Citation

Milas, Costas and Lekkos, Ilias, Common Risk Factors in the Us and UK Interest Rate Swap Markets: Evidence from a Non-Linear Vector Autoregression Approach (February 2002). Brunel University Working Paper, Available at SSRN: https://ssrn.com/abstract=301362 or http://dx.doi.org/10.2139/ssrn.301362

Costas Milas (Contact Author)

Keele University ( email )

Keele, Staffordshire ST5 5BG
United Kingdom

Brunel University London - Economics and Finance ( email )

Uxbridge
Middlesex UB8 3PH
United Kingdom
0044 1895 816268 (Phone)
0044 1895 203384 (Fax)

Ilias Lekkos

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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