Staff Reports
Trading Risk and Volatility in Interest Rate Swap Spreads
February 2004 Number 178
JEL classification: G12, G14, G24

Author: John Kambhu

This paper examines how risk in trading activity can affect the volatility of asset prices. We look for this relationship in the behavior of interest rate swap spreads and in the volume and interest rates of repurchase contracts. Specifically, we focus on convergence trading, in which speculators take positions on a bet that asset prices will converge to normal levels. We investigate how the risks in convergence trading can affect price volatility in a form of positive feedback that can amplify shocks in asset prices. In our analysis, we see empirical evidence of both stabilizing and destabilizing forces in the behavior of interest rate swap spreads that can be attributed to speculative trading activity. We find that the swap spread tends to converge to a long-run level, although trading risk can sometimes cause the spread to diverge from that level.

Available only in PDFPDF29 pages / 254 kb

For a published version of this report, see John Kambhu, “Trading Risk, Market Liquidity, and Convergence Trading in the Interest Rate Swap Spread,” Federal Reserve Bank of New York Economic Policy Review12, no.1 (May 2006): 1-13.

PDF full articlePDF13 pages / 121 kb
tools
By continuing to use our site, you agree to our Terms of Use and Privacy Statement. You can learn more about how we use cookies by reviewing our Privacy Statement.   Close