FIN-01-042

Credit Risk and the Yen Interest Rate Swap Market

July 2001

Young Ho Eom, Marti G. Subrahmanyam and Jun Uno

ABSTRACT

In this paper, we investigate the pricing of Japanese yen interest rate swaps during the period 1990-96. We obtain measures of the spreads of the swap rates over comparable Japanese Government Bonds (JGBs) for different maturities and analyze the relationship between the swap spreads and credit risk variables.
Our empirical results in the yen swap market indicate that: 1) the commonly-used as- sumption of lognormal default-free interest rates and swap spreads is strongly rejected by the data, 2) the term structure of swap spreads displays a humped-shape, and 3) the shocks in the yen swap spread are negatively correlated with the shocks in the comparable default-free spot rates, especially for longer maturities.
Our analysis also indicates that yen swap spreads behaved very differently from the credit spreads on Japanese corporate bonds in the early nineties. In contrast to Japanese corporate bonds, we find that the yen swap spread is also signicantly related to proxies for the long-term credit risk factor. Furthermore, the swap spread is negatively related to the level and slope of the term structure and positively related to the curvature, indicating that the credit "optionality" is priced in the swap rate. Thus, overall, the yen swap market was sensitive to credit risk during the period of our study.

Classification: G12, G13, G15

Young Ho Eom
Institution: Yonsei University

Marti G. Subrahmanyam
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0348
Fax: (212) 995-4233
Email: msubrahm@stern.nyu.edu
Homepage: http://www.stern.nyu.edu/~msubrahm

Jun Uno
Institution: Nikkei QUICK Information Technologies, Inc.

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