Default Risk and Innovations in the Design of Interest Rate Swaps

Abstract

The emergence of an active interest rate swap market has transformed the nature of corporate debt issuance and risk management. Many firms nowadays routinely use swaps to adjust their ratio of fixed to floating rate debt when there is a change in management's view on interest rates. For instance, if it is felt that market rates have bottomed, a firm could raise that ratio by entering a swap to pay a fixed rate and receive the prevailing level of some reference rate, such as LIBOR (London Interbank Offer Rate). There is, however, default risk on the swap. In this example, the risk is that the counterparty defaults when the fixed rate on a replacement swap is higher than the one originally contracted. Potential default risk at origination is bilateral in that each party to the agreement must consider the riskiness of the other. At any point in the lifetime of the swap, the actual default risk is unilateral in that the swap would have positive economic value to only one of its counterparties.