The Relation between Counter-Party Default and Interest Rate Volatility, and its Impact on Collateralized Interest Rate Swaps

Abstract

We present a uni ed framework to study the impact of the correlation between interest rate volatility and counter-party default probability on the credit risk of collateralized interest rate derivatives contracts. When interest rates are volatile, counter-parties are potentially more likely to default. Large moves in interest rates accompanied with counter-party default may lead to losses on interest rate derivatives even if they are collateralized. An interest rate model with stochastic volatility and a reduced-form default model, in which the default probability is correlated with interest rate volatility, are proposed and estimated from market data. Finally, a sensitivity analysis of the impact of the correlation between interest rate volatility and a counter-party's default probability on the credit risk of collateralized interest rate derivatives contracts is presented.