Swap spreads volatilities

Swap spread volatilities for several currencies are shown in Exhibit 23.6, with values that vary from about 15 bp/year to 40 bp/year. Also shown are the resulting spread risks in the euro and sterling markets for several rating categories. We will see further below that the swap model predicts reasonably accurately both the absolute magnitude of the spread risk in each market and their relative values. 

The evolution of Euro government bond swap spreads has always been linked to the performance of the peripheral spreads (or vice versa). Yet this relationship should be taken with a pinch of salt as, having the German rate in both sides of the equation, a simple spike in the German market bond volatility will make this correlation increase spuriously. 

Panel A Swap Spread Annualized Volatility for Markets Covered in the Model... 

Panel B Comparison between Typical Euro and Sterling Spread Volatilities Computed Using the Swap Factor for Different Rating Categories... 

During the financial crash of2007—2008, in reaction to bond market volatility around the world brought about by the bank liquidity crisis and subsequent global recession, the USD swap spread widened, as did the spread between 2- and 10-year swaps, reflecting market worries about credit and counterparty risk. Spreads narrowed in the first quarter of 2009, as credit concerns sparked by the 2007—2008 market corrections declined. The evolution of the 2- and 10-year USD swap spreads is shown in FIGURES 7.4 and 7.5. 

In this way, any changes of shape and perceptions of the premium for CDS protection are reflected in the spreads observed in the market. In periods of extreme price volatility, as seen in the middle of 2002, the curves may invert to reflect the fact that the cost of protection for shorter-dated protection trades at wider levels than the longer-dated protection. This is consistent with the pricing theory for credit default swaps. 

We compare in Exhibit 23.16 the volatilities of a few selected euro and US dollar factors. The common denominator is that euro volatilities are less than their US dollar counterparts. This is true for all factors if we ignore the volatility bursts sometimes observed over a few months for some factors (for instance the Industrial A factor in Exhibit 23.16). The average level of systematic risk observed amongst euro-denomi-nated fixed income instruments is more generally low compared to other markets. Exhibit 23.16 shows one case where euro volatilities seem to be catching up with US levels. A more systematic analysis of how euro volatilities have recently evolved since 2002 would show that this is an exception. On average, euro volatilities have remained low with respect to US ones. Note that this is consistent first with the predictions of the swap factor model, euro spread levels and swap volatility being low compared to other markets. 

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