Trading Risk, Market Liquidity, and Convergence Trading in the Interest Rate Swap Spread

[...]This article analyzes empirical evidence on the limits ofarbitrage in the interest rate swap market as well as on howtrading risk can affect market liquidity and amplify shocks inasset prices. We study these issues in terms of the behavior ofthe interest rate swap spread—the spread between the interestrate swap and Treasury interest rates—and the volume ofrepurchase, or repo, contracts. The type of trading activity weexamine is convergence trading, in which speculators tradeon the expectation that asset prices will converge to normal,or fundamental, levels. Convergence trades typically moveprices toward fundamental levels and stabilize markets. Bycountering and smoothing price shocks, the trading flows ofconvergence traders can potentially enhance market liquidity.However, if convergence trades are unwound prematurely,asset prices would tend to diverge further from their fundamentalvalues rather than converge to them. A prematureunwinding of these trades can occur when concerns abouttrading risks are more pronounced, and trading counterpartiesrefuse to roll over positions or internal risk managers instructtraders to close out their positions. In this instance, a form ofpositive feedback can emerge through which trading riskamplifies asset price shocks.[...]