Finance

This paper argues that liquidity differences between government securities and short term Eurodollar borrowings account for interest rate swap spreads. It then models liquidity as a linear function of two mean- reverting state variables and values it. The interest rate swap spread for a swap of particular maturity is the annuitized equivalent of this value. It has a closed form solution: a simple integral. Special cases illustrate that many realistic “swap spread term structures” can be replicated. Model parameters are estimated using weekly data from January 1988 through February 1992 on the “term structure of swap spreads.” Some simple tests of the model are performed using this data.