Volatility transmission across the term structure of swap markets: international evidence

Pilar Abad and Alfonso Novales

Applied Financial Economics, 2004, vol. 14, issue 14, 1045-1058

Abstract: The behaviour of volatility across the term structure of interest rate swaps is characterized in three currencies (Deutsche mark, Japanese yen and US dollar). For that purpose, a modified GARCH-in mean model is used allowing for seasonal patterns in the mean and variance of interest rates and asymmetric responses to interest rate surprises. Daily interest rate changes are found (a) to be predictable, following autoregressive structures, and (b) to display weekly seasonality. Additionally, interest rate volatility is shown to (a) decrease with maturity, (b) be very persistent and hence, somewhat predictable, which is important when pricing derivatives on swap products, (c) show a tendency to be lower at the beginning of the week, increasing later on, and (d) to respond asymmetrically to interest rate innovations. These properties could clearly be used in risk management with interest rate swaps. Finally, significant transmission of volatility is found from the very short-term to longer-term interest rates. This evidence supports the importance attributed by most central banks to achieving stability in short-term interest rates.

Date: 2004
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Working Paper: Volatility Transmission acros the Term Structure of Swap Markets: International Evidence (2002)
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DOI: 10.1080/0960310042000245563

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