Investments, tenth edition

  Credit Risk in the Swap Market 

 The rapid growth of the swap market has given rise to increasing concern about credit risk 

in these markets and the possibility of a default by a major swap trader. Actually, although 

credit risk in the swap market certainly is not trivial, it is not nearly as large as the magni-

tude of notional principal in these markets would suggest. To see why, consider a simple 

interest rate swap of LIBOR for a fixed rate. 

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  Futures, Swaps, and Risk Management 

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 At the time the transaction is initiated, it has zero net present value to both parties for the 

same reason that a futures contract has zero value at inception: Both are simply contracts 

to exchange cash in the future at terms established today that make both parties willing to 

enter into the deal. Even if one party were to back out of the deal at this moment, it would 

not cost the counterparty anything, because another trader could be found to take its place. 

 Once interest or exchange rates change, however, the situation is not as simple. Sup-

pose, for example, that interest rates increase shortly after an interest-rate swap agree-

ment has begun. The floating-rate payer therefore suffers a loss, while the fixed-rate payer 

enjoys a gain. If the floating-rate payer reneges on its commitment at this point, the fixed-

rate payer suffers a loss. However, that loss is not as large as the notional principal of 

the swap, for the default of the floating-rate payer relieves the fixed-rate payer from its 

obligation as well. The loss is only the  difference  between the values of the fixed-rate and 

floating-rate obligations, not the  total  value of the payments that the floating-rate payer 

was obligated to make. 

 

 

 Consider a swap written on $1 million of notional principal that calls for exchange 

of LIBOR for a fixed rate of 8% for 5 years. Suppose, for simplicity, that the yield 

curve is currently flat at 8%. With LIBOR thus equal to 8%, no cash flows will be 

exchanged unless interest rates change. But now suppose that the yield curve imme-

diately shifts up to 9%. The floating-rate payer now is obligated to pay a cash flow 

of (.09   2   .08)   3   $1  million   5   $10,000 each year to the fixed-rate payer (as long as 

rates remain at 9%). If the floating-rate payer defaults on the swap, the fixed-rate 

payer loses the prospect of that 5-year annuity. The present value of that annuity is 

$10,000  3  Annuity factor(9%, 5 years)  5  $38,897. This loss may not be trivial, but it 

is less than 4% of notional principal. We conclude that the credit risk of the swap is far 

less than notional principal.