A monetary policy–based explanation of swap spreads in China.

The dynamics of swap spreads in China cannot be explained by commonly recognized factors documented in the literature. A unique feature of China's financial system is that commercial banks are not only long‐term loan providers but also dominant bond investors. Thus, the loan prime rate (LPR) is an opportunity cost for commercial banks' bond holdings. However, the LPR is largely determined by the central bank and often deviates significantly from equilibrium. In contrast, the swap rate is largely determined by the market. Our illustrative model and empirical evidence show that the LPR and funding availability affect bond yields more than swap rates, while volatility in the money market interest rate affects swap rates more than bond yields. Therefore, the swap spread is largely driven by the monetary policy. We also show that swap spreads can be a predictor of excess returns on bonds but not swaps. [ABSTRACT FROM AUTHOR]