Interest Rate Structure and the Credit Risk of Swaps

by Katerina Simons
July/August 1993

Swap contracts have grown tremendously in the last decade. Most are interest-rate swaps, the simplest being an exchange of one party’s fixed-rate interest payments for another’s floating-rate payments. Swaps can lower borrowing costs for both parties as well as provide a tool for managing interest-rate risk. As the market for swaps grows and matures, understanding and measuring the accompanying credit risk remains a concern of bankers, regulators, and corporate users.

The credit risk of swaps arises when one party defaults and interest rates have changed in such a way that the other party can arrange a new swap only on inferior terms. It involves only the cash flows exchanged by the counterparties, and not the underlying notional principal. Previous work has used simulations of the future course of interest rates to analyze swaps’ credit risk. This study adds the interest rate forecast implicit in the yield curve to the randomly generated interest-rate scenario used in the simulations. The author shows that credit exposure is greater for longer maturities and when future rates are expected to be higher, and that the risk rises and then falls over the life of the swap.

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