Interest rate derivatives

Abstract

Swap spreads, the interest rate differentials between the fixed rates on fixed-for-floating swap contracts and the yields-to-maturity on maturity-matched government bonds, define a market for one of the most actively transacted securities in the global fixed-income arena. A large universe of fixed-income securities use interest rate swap spreads as a key benchmark for pricing and hedging. In this paper we present an empirical regression model to analyze interest swap spreads. Specifically, we focus on the determinants of swap spreads and show how the level, slope and curvature of the prevalent interest rates, the liquidity premium, and the risk premium jointly determine term structures of swap spreads. We present a theoretical/intuitive hypothesis on the effect of determinants and support it mathematically with the regression model. We then present a comprehensive overview of the mechanism and structure of the overnight index swap (OIS) which is the flagship of Indian IRS. In the second part, we do a quantitative analysis of the benchmark reference rate MIBOR(overnight) and compare it with CBLO, call and repo rates. We do a volatility analysis using the GARCH model. We estimate weighted average spreads of actually traded rates (CCBOR) and compare it with the polled MIBOR spread. In essence we test the MIBOR on the parameters required of an unbiased benchmark rate. We conclude that MIBOR has a significant upward bias and hence, though a good speculative/indicative measure, it is not a good reference rate. The next section of the report compares MIBOR and LIBOR and lastly, we recommend a few markers which might eliminate the fixing and upward bias of MIBOR.