Victor Fang

An empirical analysis of the Australian dollar swap spreads

This paper examines the relationship between the Australian dollar interest rate swap spread and the term structure of the interest rates, and also the determinants of interest rate swap spreads. For this purpose, we estimate the term structure of interest rates using the parsimonious fitting function of Nelson and Siegel [Journal of Business 60 (1987) 476] for the Australian government bonds and Australian interest rate swaps for certain maturities that are not available. We analyse the swap spread over the term structure of the government bonds and how changes in swap determinants affect the changes in swap spreads. The sample period covers the daily interval from 6 December 1996 to 31 December 1999.

Modeling volatility and changes in the swap spread

We investigate the determinants of changes in U.S. interest rate swap spreads using a model that explicitly allows for volatility interactions between swaps of different terms to maturity. Changes in the swap spread are found to be positively related to interest rate volatility, to changes in the default risk premium in the corporate bond market, and to changes in the liquidity premium for government securities. Swap spread changes are negatively related to changes in the level of interest rates and changes in the slope of the term structure. We also find that there is a strong and significant volatility interaction among spreads for swaps of different maturities and that the process for the conditional variance of the spread is highly persistent across all maturities.

Modeling the Determinants of Swap Spreads

The authors use a multivariate exponential generalized autoregressive conditional heteroscedasticity (EGARCH) model to investigate the determinants of interest rate swap spreads in Australia. They find that changes in the spread are negatively related to changes in the level of default-free interest rates and to changes in the slope of the term structure. The curvature factor of the term structure is found to be a poor proxy in explaining changes in the spread. There is a strong and significant volatility interaction among spreads for swaps of different terms to maturity. The process for the conditional variance of the spread is highly persistent across all maturities. Credit risk but not swap market liquidity is also an important source of variation in Australian swap spreads.

Low‐Frequency Volatility of Yen Interest Rate Swap Market in Relation to Macroeconomic Risk

Using ‘low-frequency’ volatility extracted from aggregate volatility shocks in interest rate swap (hereafter, IRS) market, this paper investigates whether Japanese yen IRS volatility can be explained by macroeconomic risks. The analysis suggests that this low-frequency yen IRS volatility has strong and positive association with most of the macroeconomic risk proxies (e.g., volatility of consumer price index, industrial production volatility, foreign exchange volatility, slope of the term structure and money supply) with the exception of the unemployment rate, which is negatively related to IRS volatility. This finding is fairly consistent with the argument that the greater the macroeconomic risk the greater is the use of derivative instruments to hedge or speculate. The relationship between the macroeconomic risks and IRS volatility varies slightly across the different swap maturities but is robust to alternative volatility specifications. This linkage between swap market and macroeconomy has practical implications since market makers and hedgers use the swap rate as benchmark for pricing long-term interest rates, corporate bonds and various other securities.

Links among interest rate swap markets : U.S., U.K. and Japan

Variance decomposition and impulse response analysis of the links in swap spreads in the U.S., the U.K., and Japan indicates that across all swap maturities and in all three currencies, the slope of the risk-free term structure makes the greatest contribution, and the contribution is greater for longer terms to maturity. The contributions of interest rate volatility, the liquidity premium, and the corporate spread are small or negligible. There is a significant bidirectional influence (particularly through term structure slope) between the U.S. and U.K. swaps markets across maturities. The U.S. and U.K. swap markets have no major impact on the Japanese swaps market, and the Japanese market has a negligible influence on the U.S. and U.K. swaps markets.

Non‐Tradable Share Reform, Liquidity, and Stock Returns in China

This article studies the influence of the non-tradable share reform in the cross-section of stock returns in China. Prior research has generally neglected this important development in the Chinese stock market. We find that the firm-specific illiquidity measures that reflect direct transaction costs, price impact and difficulties in trading immediacy, exhibit a positive and significant relationship with stock returns. These effects are particularly pronounced after the non-tradable share reform. Furthermore, in the post-reform era, portfolios with high illiquidity (i.e. high relative bid–ask spread, high Amihud illiquidity, low Amivest liquidity ratio) significantly outperform portfolios with low illiquidity, controlling for size, and book-to-market effects.

Business Cycles and the Impact of Macroeconomic Surprises on Interest Rate Swap Spreads: Australian Evidence

This study examines the response of Australian interest rate swap spreads to the arrival of macroeconomic news information during the economic expansion and contraction periods. We find that the impact of news announcements on swap spread change differs and largely depends on the state of the economy. The unexpected inflation rate is the only news released that has significant impact on swap spreads across all maturities during contractions and remains the important news announcement throughout the business cycles, while the unanticipated unemployment rate tends to be more relevant to 10-year swap and the unanticipated change in money supply tends to be more relevant to 4- and 7-year swaps during expansions. We also find shocks from these news surprises appear to have significant impact on the conditional volatility of the swap spread change during both economic phases. The macroeconomic shocks in general are negatively related to the conditional volatility of the swap spread change, suggesting that the newsworthy announcements tend to reduce uncertainty on the news announcement days in the swap market during expansion and contraction periods.

A Heuristic Approach to Asian Hedge Fund Allocation

The authors first note that, unlike traditional investment vehicles, hedge funds seem to produce return distributions with significantly non-normal skewness and kurtosis. Hedge fund managers that apply the mean-variance optimization approach to form optimal portfolios may find that approach no longer appropriate. Moreover, utilizing a portfolio optimizer to perform portfolio allocations will cause what is known as the “butterfly effect”—that is, small changes in inputs, especially mean returns, can cause large changes in the optimal asset weightings. This phenomenon, coupled with the illiquidity of hedge funds, may prompt hedge fund managers to consider alternative approaches to portfolio allocation. In this study, the authors introduce a practical heuristic approach using the semi-variance (that better accounts for non-normality in hedge fund returns) as a measure for downside risk. This heuristic approach is able to provide better forecasts, stable portfolio allocations, and more diversification than the optimization approach. The authors find the “butterfly effect” in their sample of Asian hedge funds when using portfolio optimizers resulting in dramatic changes in optimal weights over time. They also find that their risk-return approach recommends portfolio with higher returns when compared with optimizers. In risk-reward comparisons against the optimizers, the heuristic approach yields the highest return to standard deviation and return to semi-deviation ratio (trade-offs).

Volatility transmission between stock and bond markets: evidence from US and Australia

This paper investigates the cross-market informational dependence between these assets under disparate interest rate conditions of the U.S and Australia. With conditional variance as a proxy for volatility, we use the BEKK – a matricular decomposition of the bivariate GARCH (1,1) model to examine the cross-market contemporaneous effect of information arrival. Applying the model to the stock and bond indices of both countries, we find evidence of volatility spillover, thereby supporting the notion of informational dependence between each market. JEL Classification:G11, G12

Credit Risks of Interest Rate Swaps: A Comparative Study of CIR and Monte Carlo Simulation Approach

This paper compares the credit risk profile for two types of model, the Monte Carlo model used in the existing literature, and the Cox, Ingersoll and Ross (CIR) model. Each of the profiles has a concave or hump-backed shape, reflecting the amortisation and diffusion effects. However, the CIR model generates significantly different results. In addition, we consider the sensitivity of these models of credit risk to initial interest rates, volatility, maturity, kappa and delta. The results show that the sensitivities vary across the models, and we explore the meaning of that variation.