The Term Structure of Money Market Spreads During the Financial Crisis

Josephine Smith, Stern School of Business, New York University

1st Jun 2012  11:30 pm - Room 214/215, H69 - Economics and Business Building

I estimate a no-arbitrage model of the term structure of money market spreads during the recent financial crisis to identify how much of the sharp movements in spreads can be attributed to observable interest rate, credit, and liquidity factors. The restrictions of the model imply that longer- term spreads are linear, risk-adjusted expected values of future short-term spreads. In addition, the linear representation of spreads can be partitioned into two distinct components: one related to time-varying expectations of spreads, and the second to time-variation in risk premia. Estimation of the model highlights the importance of time-variation in risk premia. Up to 50% of the Variation of spreads is explained by time-varying risk premia, and risk premia has significant predictive power for spreads.