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The effect of systematic risk factors on counterparty default and credit risk of interest rate swaps

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  • David Volkman

Abstract

This research investigates the effect of specific systematic risk factors on credit risk pricing and capital allocation of interest rate swaps. Because of the stochastic nature of uncertain future cash flows and interest rates, practitioners typically employ the Black-Scholes option pricing model in combination with a simulation analysis to establish capital requirements and estimate the shadow price of an interest rate swap. However, this practice of pricing swap risk excludes systematic risk factors that affect the risk shadow price, thereby underestimating the capital allocation required for financial institutions. This research demonstrates the effect of risk mispricing when simulation models ignore systematic risk factors such as model risk, convexity risk, and parameter risk on the pricing of interest rate swaps. Copyright Springer 2000

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  • David Volkman, 2000. "The effect of systematic risk factors on counterparty default and credit risk of interest rate swaps," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 24(3), pages 215-231, September.
    • Handle: RePEc:spr:jecfin:v:24:y:2000:i:3:p:215-231
    DOI: 10.1007/BF02752604
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    References listed on IDEAS

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    1. Campbell, John Y, 1986. "A Defense of Traditional Hypotheses about the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 41(1), pages 183-193, March.
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