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Interest rate structure and the credit risk of swaps

Author

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  • Katerina Simons

Abstract

Swap contracts have grown tremendously in the last decade. Most are interest-rate swaps, the simplest being an exchange of one partys fixed-rate interest payments for anothers 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.

Suggested Citation

  • Katerina Simons, 1993. "Interest rate structure and the credit risk of swaps," New England Economic Review, Federal Reserve Bank of Boston, issue Jul, pages 23-34.
    • Handle: RePEc:fip:fedbne:y:1993:i:jul:p:23-34
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    File URL: http://www.bostonfed.org/economic/neer/neer1993/neer493b.pdf
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    References listed on IDEAS

    as
    1. Frederic S. Mishkin, 1990. "Yield Curve," NBER Working Papers 3550, National Bureau of Economic Research, Inc.
    2. Katerina Simons, 1989. "Measuring credit risk in interest rate swaps," New England Economic Review, Federal Reserve Bank of Boston, issue Nov, pages 29-38.
    3. Elizabeth Laderman, 1993. "Risks in the swaps market," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue mar12.
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    Cited by:

    1. Marianne Gizycki & Brian Gray, 1994. "Default Risk and Derivatives: An Empirical Analysis of Bilateral Netting," RBA Research Discussion Papers rdp9409, Reserve Bank of Australia.

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    Keywords

    Interest rates; Swaps (Finance);

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