Credit Risk and Interest-Rate Swaps
An interest-rate swap is a contract by which the parties agree to exchange a constant, fixed payment stream for a variable payment stream. The variable payment stream, the so-called floating leg of the contract, is typically linked to three- or six-month LIBOR rates, an interbank deposit rate which will be defined below. The fixed leg is typically set so that the contract has zero initial value and the size of this fixed leg is referred to as the swap rate. The actual dollar size of the payments is computed from a notional value of the contract, but in interest-rate swaps this notional value is only for calculation purposes: it is never exchanged.
The market for interest-rate swaps has reached an enormous size. Current estimates in Bank of International Settlements (2003) are that the size of the euro swap market by the end of 2002 had an outstanding notional amount of $31.5 trillion, and that the corresponding amount for the dollar market was $23.7 trillion. This is of course an enormous amount but it tends to exaggerate the size of the cash flows involved since it is common practice in the swap markets to close out positions by taking new offsetting positions in swaps instead of getting out of the existing swaps.
Still, the volume is large, and it is partly a reflection of the fact that swap markets are increasingly supplementing government bonds for hedging and price discovery in fixed-income markets. This leads to the natural question of whether swap curves are replacing yield curves on government bonds as “benchmark” curves. A benchmark curve is a curve against which prices of other securities are measured, but it is also a natural question to think of whether the swap curve is a better measure of the riskless rate. Whether we use swap curves as benchmarks or even consider using them as proxies for a riskless rate, we need to understand their meaning and their dynamics.
In this chapter we focus on understanding the relationship between swap pricing and credit risk. Credit risk enters in two ways. First, since the contract is typically an over-the-counter instrument (i.e. the counterparty is not an organized exchange), there is counterparty credit risk in the contract. And second, the floating rate on which the contract is based is the so-called LIBOR rate, which is sensitive to, among other things, changes in credit quality. We start out by defining the LIBOR rate.