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Hedging demand and near-zero swap spreads: Evidence from the Chinese interest rate swap market

Author

Listed:
  • Li, Shaoyu
  • Zhu, Chunhui
  • Shang, Yuhuang
Abstract
Interest rate swap plays an essential role in the Chinese fixed-income market as a mainly hedging instrument. However, the market pricing anomaly of the near-zero swap spread violates the non-arbitrage assumption. Investigating the dynamics of pricing factors on interest rate swaps is meaningful to explain near-zero swap spreads. This paper employs a vector autoregressive model with time-varying parameters (TVP-VAR) model to examine the dynamic effects of pricing factors on swap spreads from a business cycle perspective. An analysis of the main three swaps with 1-year, 2-year, and 5-years maturities indicates that the TVP-VAR model accurately describes the time-varying features of the economic determinants. The TVP-VAR model has higher forecasting accuracy than the TVP model, particularly in the first-three months after the start of Covid-19 pandemic. The level, interest rate volatility (or economic policy uncertainty index), and stock market volatility as the proxies for hedging demands show opposite effects to the theoretical predictions. These effects are evident before 2010 (international financial crisis), during a short period in 2015 (stock market crashes), and after 2019 (Covid-19 pandemic). Thus, we provide different explanations of the effects of the hedging demand on near-zero swap spreads.

Suggested Citation

  • Li, Shaoyu & Zhu, Chunhui & Shang, Yuhuang, 2023. "Hedging demand and near-zero swap spreads: Evidence from the Chinese interest rate swap market," The Quarterly Review of Economics and Finance, Elsevier, vol. 91(C), pages 170-185.
    • Handle: RePEc:eee:quaeco:v:91:y:2023:i:c:p:170-185
    DOI: 10.1016/j.qref.2022.10.011
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    References listed on IDEAS

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    More about this item

    Keywords

    Near-zero swap spreads; Time-varying; Business cycle; Hedging demand;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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