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Modeling Money Market Spreads: What Do We Learn about Refinancing Risk?

Vincent Brousseau, Kleopatra Nikolaou and Huw Pill

No 2014-112, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We quantify the effect of refinancing risk on euro area money market spreads, a major factor driving spreads during the financing crisis. With the advent of the crisis, market participants' perception of their ability to refinance over a given period of time changed radically. As a result, borrowers preferred to obtain funding for longer tenors and lenders were willing to provide funding for shorter tenors. This discrepancy resulted in a need to refinance more frequently in order to borrow over a given horizon, thus increasing refinancing risk. We measure refinancing risk by quantifying the sensitivity of the spread to the refinancing frequency. In order to do so we introduce a model to price EURIBOR-based money market spreads vis--vis the overnight index swap. We adopt a methodology akin to a factor model in which the parameters determining the spreads are the intensity of the crisis, its expected half-life, and the sensitivity of spreads to the refinancing frequency. Results suggest that refinancing risk affects the spread significantly across time, albeit in a largely varying manner. Central bank interventions have reduced the spreads as well as the effect of refinancing risk on them.

Keywords: Financial crisis; liquidity risk; money market spread; money markets; refinancing risk (search for similar items in EconPapers)
JEL-codes: E58 G12 G21 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2014-11-19
New Economics Papers: this item is included in nep-eec, nep-fmk, nep-mac and nep-mon
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Citations: View citations in EconPapers (1)

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