Do you want to swap? A study of the liquidity risk in the SEK interest rate swap market

Abstract

Interest rate swaps are one of the world’s most essential interest rate derivatives. It is therefore important to understand the pricing of these agreements, and how the market is functioning. This study is inspired by Sveriges Riksbank´s autumn survey of 2022, where a majority of the market participants felt that the Swedish fixed-income market – including the interest rate derivatives market – was functioning poorly, partially due to liquidity problems. In this study, we are centring on Swedish Krona (SEK) denominated interest rate swaps and investigating to which extent the swap spread can be attributed to the risk of illiquidity in the market, and how the market is functioning. This study examines the two-, five-, and ten-year tenors of the swap curve, along with the amount of interest rate swap transactions, from November 2015 to February 2023. Liquidity is proxied using a Swedish version of the more commonly used Treasury-Eurodollar (TED) spread. The results show that the liquidity risk premium is significant, but negative, for the five- and ten-year tenors. This indicates that there exists a liquidity risk discount. But there is no significant difference in liquidity risk discount between the tenors. Furthermore, we find no evidence of a deterioration of the liquidity over the period, only that the liquidity reverted in the post-covid-pandemic era from a previously higher level.