What Drives Swap Spreads, Credit or Liquidity

Abstract: This paper investigates the determinants of swap spreads. Compared with previous work done in this area, such as the seminal paper by Duffie and Singleton (1997), the paper includes daily credit spreads data in the time series framework. The issue is whether 'liquidity' or 'credit' (or both) is the main determinant of swap spreads dynamics. Our results agree with the prevailing view among swap traders that swap spreads are mainly an indicator of 'market liquidity'. However, the dynamics are influenced significantly by 'credit' over longer horizons, although credit is not the main driving force. LIBOR rate dynamics seem to play a relatively minor role in this setting.