Drivers of Swedish Swap Spreads

Abstract: According to a survey carried out by Bank of international settlements (BIS) and published by the Swedish Riksbank, the average turnover in Swedish interest rate swaps totaled almost SEK 20 billion per day in 2004. The International Swaps and derivatives association (ISDA) reported that the notional outstanding amount of privately negotiated (over the counter) derivatives at the end of 2004 was over $164 trillion around the world compared to the $31 trillion aggregated principal of all the worlds’ bond markets taken together. In this paper, we investigate the drivers of SEK interest rate swap spreads for 5 and 10 year maturities during the period of 1999-2006. We apply an error-correction methodology based on the concept of cointegration. We find that SEK swap spreads are cointegrated with the Swedish borrowing need and the credit spreads on Swedish mortgage bonds. However, only the credit spread is significant in the long term model, suggesting that the risk in the Swedish banking sector is a key swap spread determinant on a long-term horizon. We then estimate a short term error-correction model that integrates the long-term relationship together with six short term determinants: the slope of the treasury yield curve, implied volatility of CAP contracts, the difference between on-the-run and off-the-run yields, the Swedish borrowing need, Euro swap spread and the credit spread. Our result shows that the slope of the yield curve, the volatility, the off/on the run spread, the Euro swap spread and the credit spread are important determinants of SEK swap spreads in the short run.