The components of interest rate swap spreads: Theory and international evidence

This article contains both a theoretical and an empirical analysis of the components of interest rate swap spreads defined as the difference between the fixed swap rate and the risk-free rate of equal maturity. The components are determined by expected LIBOR spreads, default risk, and market structure. A model of the swap market incorporating debt market imperfections and corporate financing choices is used to explain participation by both swap buyers and sellers. The model also motivates an empirical relationship between swap spreads and the slope of the risk-free term structure. The article then provides empirical evidence on the cross-sectional and time-series variation of swap spreads in seven international markets. The evidence is consistent with the suggested components across both markets and swap maturities as well as over time. (C) 2003 Wiley Periodicals, Inc.