Determinants of interest rate swap spreads
Larry H.P. Lang a,b, Robert H. Litzenberger c, Andy Luchuan
Liu d,*
a Chinese University of Hong Kong, Hong Kong, People's Republic of China
b University of Chicago, Chicago, IL USA
c Wharton School, University of Pennsylvania, Philadelphia, PA, USA and Goldman Sachs and
Company
d Faculty of Business, City University of Hong Kong, Tatchee Avenue, Kowloon, Hong Kong,
People's Republic of China

Abstract
This study argues that an interest rate swap, as a non-redundant security, creates
surplus which will be shared by swap counterparties to compensate their risks in swaps.
This action in turns a€ects swap spreads. Analyzing the time series impacts of the
changes of risks of swap counterparties on swap spreads, we conclude that both lower
and higher rating bond spreads have positive impacts on swap spreads. We also derive a
risk±spread relation to test if swap counterparties are ®rms with di€erential credit ratings.
Since the risk allocation between swap counterparties varies over business cycles,
hence this factor needs to be controlled. We conclude that (1) similar results hold if the
business cycle factor is controlled and (2) swap spreads contain procyclical element and
are less cyclical than lower credit rating bond spreads. Ó 1998 Elsevier Science B.V. All
rights reserved.