Credit Risk and the Pricing of Japanese Yen Interest Rate Swaps

Marti G. Subrahmanyam, Young Ho Eom and Jun Uno

New York University, Leonard N. Stern School Finance Department Working Paper Seires from New York University, Leonard N. Stern School of Business-

Abstract: In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990 to 1996 with particular reference to credit risk. We estimate the default-free term structure of interest rates using the prices of ten-year Japanese Government Bonds (JGB's), using the basis -spline method. Since there are fewer observations for the swap market, the term structure of swap spot rates is estimated using the more parsimonious polynomial method of Nelson and Siegel. This term structure is then used as the reference for the determination of the spread of swap rates over comparable default-free rates. Two alternative definitions are used for the swap spread. The first is based on the difference between the swap rate and the default-free par-bond yield of the same maturity. The second is based on the difference between the implied zero-coupon (spot) rates in the swap market compared to those in the JGB market. We are able to fit the swap and JGB term structures with low fitting errors of approximately 11 basis points and 2 basis points respectively in terms of the mean absolute deviation. We investigate the statistical properties of the default-free spot rates and the swap spread and reject the hypothesis of lognormality of both variables. The swap spread in the yen market displays an inverted U-shape, in contrast to the dollar market where it rises monotonically. This may be partly explained by liquidity effects in the JGB market as well as market segmentation. Surprisingly, the yen swap spread is only weakly linked to the yen swap spread, although there are indications of causality, especially at the short end, from the dollar market to the yen market. We then investigate how yield curve as well as credit risk factors affects the spread. Our regression results show that the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature. The spread is also positively related to proxies for the short- and long-term credit risk factors.

Date: 2000-03
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Citations: View citations in EconPapers (2)

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