Pricing

Swap

Default

Risk

F. EricH. Sorensen and Thierry Bollier

Withthegrowthin themarket interest swapshascomea growingneedto understand rate for thepotential defaultrisksof theseinstruments. general,swapparticipants dealwith In can defaultrisk by seekingto mitigateit (by dealingonly with AAA-rated counterparties, for example).Alternatively, potentialcounterparties attemptto come to some agreement can aboutthe degreeof defaultriskand use thatknowledge "price" to theirpositions. A modelof swapdefaultriskevaluates jointly the probability the swapcounterparty of and the cost (or impact) the default the solventparty. Themodelhelpsto defaulting of for establishthe correctlevelfor a swap betweenrisky (or potentially risky)parties.The key considerations theswapparties' are creditconditions theshapeandvolatilityof theyield and curve.

variety of issues affectthe defaultrisks of

interest rate and currency swaps. While the economic causes of issuer default and the natureof the probabilityof default are similarfor both swaps and bonds, the consequences of default for the solvent counterparty(or bondholder) differgreatly between swaps and bonds. For example, a swap that is currently an asset (in the money, as opposed to a liability)will represent a loss in value if the counterpartydefaults. By contrast,a swap that is neither an asset nor a liability(i.e., that is at the money) may not create any economic loss if the counterpartydefaults. Several factors complicate the pricing of default risk in the current marketplace. In practice, for example, counterpartiesmay seek to mitigate risk ratherthan price it, or they may seek to ration credit rather than price it. Common methods of mitigatingcredit risk include rationingthe amount of swaps with any one counterparty,entering into mark-to-market agreements, and transactingonly with AAA-rated special-purpose credit subsidiaries such as Salomon Brothers'sSWAPCO. Ratherthan mitigatingcreditrisk, we can seek to price it. That is, we can model the magnitude of potential default risk and estimate a reasonable adjustment to the fixed rate in an interest rate swap. In theory, this coupon adjustmentcan range
EricH. Sorensen Director Quantitative is of Research headofthe and Derivatives Research Groupat SalomonBrothers Inc. Thierry F. Bollier is Managing Directorand head of GlobalFixed Income Derivative Research Salomon at Brothers.

from less than one basis point to upwards of 15 basis points, depending on credit quality and existing market conditions. The fixed-rate adjustment seeks to compensate swap parties for default risk, just as higher coupon rates compensate for the greater risk of lower-rated issues in the bond market. This article contrasts the differences between swaps and bonds to develop the key determinants of default risk. The majorconsiderationsin pricing default risk using a bilateral approach include a combinationof the two parties' credit conditions, the existing swap books (or portfolios) that each party has with the other, the shape and volatility of the yield curve, and exchange rates. Academic and practitionerinterest in analyzing default risk is not new.' Considerableanalysis has focusedon the determinants the yield spreads of between risky debt, such as corporatebonds, and riskless debt, such as default-freeTreasurybonds. bond researchers have analyzed the theCorporate oretical pricing structure of the default premium along the yield curve. After adjustmentfor embedded options in corporatebonds, creditspreads presumably widen, the longer the term to maturity. In addition, empiricalstudies typically report that ex antedefaultpremiumshave historically provided returns sufficient to compensate for the realized defaultsin a diversifiedcorporate municipalbond or portfolio. There exist less historical data regarding the experienceand incidence of defaults on swaps. We would expect, however, that with the passage of

Financial AnalystsJoumal/ May-June 1994

23

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time default risk pricing should adjust to supply and demand forces in the swap marketas it has in the bond market.Just as a lower-ratedbond issuer pays a higher coupon, the lower-ratedswap party should pay (receive) a higher (lower) fixed swap rate. We begin by considering default risk in contractual swap transactions. We then develop a credit pricing model that values the default risk in each party's transactionby modeling the replacement cost of the swap in the event of default. Central to the model is the joint evaluationof the and defaulting thecostof of probability thecounterparty to thedefault thesolventparty.Severalaspects of the model help to establish the correctlevel for a swap between risky (or potentiallyrisky) counterparties. To the extent that both parties have default risk, the evaluation of the pricing is bilateral; both counterpartiesshould price the risk.

offsets the impact of potential replacement cost in the portfolio; this might happen, for example, if the party enters into an offsetting swap with the same counterparty. Third, the pricing of default risk will depend on the existing shape and estimated volatility of the yield curve, because the shape and volatilityof the curve will determine the option value embedded in the replacementcost of the swap. Fourth, existence of market frictions may make it difficult to isolate easily the marginal pricing of default risk and to apply it readily to an actual transaction. That is, for the model to be completely useful, both swap parties must agree with their mutual credit conditions.This may not always be the case; for example, parties may not share the same information about market conditions or the specifics of each other's credit status. Nevertheless, a default risk model can serve as a key building block in creating efficient swap pricing.

IN IMPLICrTA SWAP RISK DEFAULT

In a swap, the participantsperiodically exchange notionalamounts. Thereis, however, no lump-sum exchangeof principalat the beginningor at the end of the term of the swap, as there is with a bond. By the very nature of an interest rate swap, both parties face some probabilityof default. In a default, the solvent party will recover only part (if any) of the replacementcost due from the defaulting party. But if it has a payment due, the solvent party must pay the full replacementcost. Because of this asymmetry, swaps take on option-likecharacteristics,and their valuation requiresoption-like analysis.2 This article attempts to establish the underpinnings of an approachto modeling default risk. First, assuming that one party has the highest possible rating of AAA, the pricing of the swap will depend on the rating of its counterpartyand the nature of the transaction. If both parties have some degree of credit risk, there should be a mutual, or "two-way," perspective in pricing credit risk. The pricing of the risk will depend on the combination of the two parties' credit conditions. Whether the credit ratings of the two are equal or unequal-and whether they are high or low-will play a part in the credit model. Second, the pricing of default risk will depend on the swap books (or portfolios) that each party currently has with the other. For example, if one party has in its portfolio existing swaps with the same counterparty, an additional swap may raise or lower the default risk of the party's overall portfolio. It will moderate the risk if the new swap

Quotes Swap Spreadsand Midmarket

In a macroeconomic sense, the midmarket swap curve reflects the consensus pricing of fixedfor-floating-rateswaps along the term structure, typically out to 10-year maturities and beyond. Swap dealers assume that the midmarket swap rates apply generally to AA-rated parties. In reality, the midmarketrates reflect the aggregate supply and demand schedules of myriad market participants. The midmarketswap rates reportedby a swap intermediaryrepresent likely levels, but not necessarily levels at which the entire market can actuallytransact.It is not criticalthat theratebe an unambiguous A or AA-rated benchmark. It is critical, however, that it be a macro benchmark against which all potential transactions can be gauged. Dealerstypicallyquote a swap rate as a spread over the currentTreasuryrate for the given maturity. For example, the U.S. 10-year swap spread over Treasuries has varied from 30 to over 100 basis points in recent years. The widening and contractingof midmarketswap spreads, however, does not capturespecificadjustmentsin fixed rates attributableto specific counterparty default risk. Figure A shows the adjustments to midmarket rates that result from the default-risk pricing model developed in this article. The figure illustratesthe fixed-rateadjustment when an AAA-rated party receives (pays) fixed from (to) an A-rated counterparty. The adjust-

24

FinancialAnalysts Journal / May-June 1994

Figure A. 10-Year Swap Rates, MidmarketRates and Default Model Adjusrient fbr AAA versus A Counterpartes, 1987-93
120 100 80

20

'88

'89

'90

'91

'92

Midmarket 10-Year Swap Spread over Treasury Rates 6

-2 -60
-8

_-_

--

'88

'89

'90

'91

'92

---

Bilateral Adjustment (AAA receiving fixed from A) Bilateral Adjustment (AAA paying fixed to A)

ments range from less than one to a few basis points over the cycle. They vary over time because of changes in the yield curve's slope, in volatility and in the default risk premium. Specifically, the adjustments were wider in 1987 and 1990 because of wider quality spreads in the corporate bond market. If the AAA party is paying fixed to the A party, an adjustment to the midmarket coupon produces a lower coupon. Note, however, that the pay and receive adjustments do not merely mirror each other. As of October 1993, for example, the model would have prescribed that an AAA-rated party pay midmarket less 2.5 basis points when paying fixed to an A-rated party, and that an AAA-rated party receive midmarket plus 0.90 basis point when receiving fixed from an A-rated party. The larger adjustment for paying than for receiving reflects the upward slope of the yield curve.

Risk;? Pncing or MitgatingDefauHt

In a typical interest rate swap, one party agrees to pay a counterparty a periodic floating rate over the life of the swap and to receive in return a level stream, or annuity, for a fixed term. When both parties to the contract have promised payments during the life of the contract, there are effectively two options.

The receiver of fixed is short an option that represents possible default by the payer of fixed; it is also long an option that represents its own possible default. The payer of fixed holds the opposite position. It is likely that one of the two positions is more valuable that the other-that is, the option position of one party is more valuable than the option position of the other party. It is important to note that the options in default modeling are exogenous. The option is "exercised" and alters value in the event of default; it is not exercised to improve one party's position. Nevertheless, in analyzing the value of credit, it is useful to invoke theory on the pricing of options to pay or receive fixed. The options' values depend on the potential paths of all future replacement values. If the swap has positive replacement cost (or is a net asset) at any time, then there is a high risk of default. At any time, the expected value of all future defaultdriven replacements represents the credit risk. In general, dealing with this risk will fall into two categories having to do with either pricing the default risk or with mitigating the default risk. Dealers and swap parties have any number of ways to adjust the risks described above without making direct price or swap-rate adjustments. A high-rated swap participant may choose to ration or limit the amount of credit exposure it faces. Some dealers ration the notional amount of swaps they are willing to enter into with a single lowerrated counterparty. In addition, some dealers will limit the maturity of the swap in order to control their credit exposure. Alternatively, a high-rated swap party can buy protection against default by using an additional derivative structure. For example, it can sell to the same counterparty a put option on an existing swap. This reduces its credit exposure because the receipt of the option premium offsets the risk that the lower-rated counterpartywill not be able to make future payments. There are also ways by which swap parties can continuously "control" the magnitude of replacement costs throughout the life of a swap, regardless of interest rate changes. For example, a markto-market agreement automatically prompts the riskier party to transfer collateral to reduce any replacement cost liability. As market rates move against the risky party, it posts collateralin much the same way as futures traders meet margin requirements.4Counterpartiescan also control replacement cost risk by using coupon reset procedures. If a change in interest rates leads to an

Financial Analysts Journal / May-June 1994

25

unrealized receivable, one party makes a payment and the coupon is reset so that the swap value remains at or near zero.

MODEUNG DEFAULT-RISK PRICING

What is the expected value of all future defaultdriven replacement costs, and how can we model the aggregate risk? Because each counterpartyis short an option that the other party will default, we can use option pricing techniques to determine the magnitude of each party's default exposure. There are two components to the problem. The first is the probability that one party will default. The second is the expected impact of the default on the solvent counterparty. Consider the case in which only one party to the swap is exposed to default risk. A "one-way," or "unilateral," default exposure may exist because one party has no probabilityof default under any future economic (or corporate) scenario. For example, we might assume that an AAA-rated partybears approximatelyall the default risk when entering into a contract with a lower-rated counterparty. Such an exposure might also exist if most (or all) of the swap's expected future values or replacement costs are negative to one party and positive to the counterpartyunder any future interest rate scenario. If the AAA party expects the swap will always be a net liabilityand never a net asset, then the "impact"of default will be negligible. This may happen if the AAA party is paying fixed and rates have fallen significantly,or if the AAA is receiving fixed and rates have risen significantly. Impact of Default This second dimension highlights the relative tradeoff between interest rate (or principal) risk and counterpartycredit risk. An AAA-ratedparty bears the most risk when its counterpartyhas the lowest possible credit rating and expected replacement costs are the highest possible. Conversely, if expected replacement costs are the lowest possible, then the counterparty'scredit rating will not be of vital concern. In the event of default, the realized cost and the impact of replacementwill be
low.

0.075 per $100), then the currentvalue of the swap is at approximately a 22.5% premium over par (0.75 x 300).5 This means that, for a $100-million notional amount, the swap has $22.5 million of asset value to X (the receiver of fixed), because rates have fallen by 300 basis points. The swap is a liability (or payable) for Y of equal magnitude. In this scenario, the credit exposure of the receiverof fixed becomes larger as the credit quality of the counterpartydeclines. Even if both counterparties are rated A, it is the receiver of fixed that largely bears the risk. In general, we can view party X's exposure to Y's credit as a series of European-style swap options to replace the flows that are lost after a default. As party X is receiving fixed in the swap, then each option represents the right to receive fixed, multiplied by the probabilityof default associated with the option expiration date. In order to simplify the analysis, assume there is only one possible date for default.6 The net option value to party X is the value of a standardEuropeanswap option times the probability of default for that date. This value or credit risk is amortized over the remaining life of the swap to produce an adjustment to the midmarket swap level at which X should be willing to transact with Y. We now focus on understanding the qualitativebehaviorof the adjustmentthat must be made to the midmarketlevel. The value of the option that X is effectively exposed to Y's credit can be written as follows:7
CRx= Py * RVx

(1)

where CRx = the credit-riskadjustment allocated to Y's risk of default, py= the probabilitythat Y will default on the single default date, and RVX= the value of the option for X to replace the swap (maximum of net asset value or zero).8

DEFAULT MODEUNG UNILATERAL RISK

Assume a one-way default exposure-for example, a swap party (X) that is receiving fixed from a counterparty(Y) and paying floating. Assume that this swap has 10 years remaining and a coupon of 10%,and that the current10-yearrate has fallen to 7%. If the swap has a durationof 7.5 (or a DVO1 of

In the example above, with X receiving fixed and a currentasset value of 22.5%, future values of RVX are likely to be positive. Under extreme assumptions, the credit risk can be large. If the path of future interest rates is predominantlyin the region of declining rates, then the asset value of the swap to X will probablyrise further. Other things equal, the higher the volatility of future rates, the more option value will rise. In addition, if the credit quality of Y deteriorates, the increased likelihood of default will further exacerbate the risk of re-

26

1994 / AnalystsJournal May-June Financial

placement at adverse coupon levels. If the two counterparties were to renegotiatethe coupon level in accordancewith a unilateralmodel, the adjustment could be a significantlypositive number.9 The situation does not have to be as dramatic for a unilateral default risk model to be valid in pricing swaps. A unilateralmodel can be used to determine the correct adjustment to midmarket swap rates for a new par swap. The credit reserve can be significant for par swaps when, for example, one party is rated AAA and the counterparty is not, or when the yield curve implies forward rates will rise or fall steeply. To calculate the expected value of all future levels of CRx,we can solve the option problem by using a term structure model for future interest rate paths. Applying this model to value the default exposure to X, we will find that the value depends on the expected forward interest rates, the volatility of forward interest rates and the potential future probabilitiesthat Y might default. It is important to address what we mean by future interest rate paths and expected forward interest rates. Mathematically,the fixed rate in a swap is the annualized rate that equates with the present value of future interest rate paths for the floating rate. If, on the one hand, the currentyield curve is upward sloping, then the most likely path of future short rates is a rising pattern. If, on the other hand, the current yield curve is downward sloping, then the future rates representa declining pattern. In late 1993, for example, the swap rate curve was steep-rising from 3%for three-monthLIBOR to 6.2% for 10-year swaps. To determine the pattern of future rates, we presume that the 6.2% fixed 10-year rate is the geometric average of the current and future paths of short-termrates. This is the most parsimonious assumption in pricing swaps-namely, modeling expected future rates as though they have some volatility but are on average centered around the forward rates implied by the observed fixed rates along the current yield curve. Thus, in late 1993, we would have expected the five-year rate five years hence to average approximately 7%-considerably higher than the late 1993 five-year swap rate of 5.5% and considerably higher than the 6.2% rate of the 10-year swap originatingin late 1993. (The current10-year rate is roughly the average of the currentfive-year rate and the future five-year rate at a date five years forward.) In this scenario, the replacementvalue for the receiver of fixed in the 10-yearswap at a point five

years from now is likely to be a liability (not an asset), because the five-year rate is likely to be 7% (higher than the 6.2% prevailing rate). In general, if the yield curve is steep (inverted), the receipt of fixed will likely be valued as an asset (liability)in early years and a liability (asset) in later years.

New ParSwaps
Consider, more generally, the default risk adjustment for a new par swap. For simplicity, assume that the midmarketswap level represents the rates at which AAA counterparties would transact,and that counterpartyX is rated AAA so that the probabilityof default is zero. Assume also that counterpartyY is lower-ratedand has a risk of default. If X is receiving (paying) fixed, the option to replace the swap represents the option to receive (pay) fixed at the originalcoupon level. The amortized value of CRX determines the adjustment that X would make to the midmarket-levelcoupon for swaps with Y. For given values of PYand RVX, X would require a higher coupon if receiving fixed and a lower coupon if paying fixed. Now let us examine the impact of changing the default probability PYand the shape of the yield curve. If Y's creditdeteriorates,then PY increasesand the magnitudeof the default risk (CRx) increases. If X is paying fixed, the coupon it pays would be adjusted downward. If X is receiving fixed, the coupon it receives would be adjusted upward. If P. = 0, there would be no adjustment necessary, because both X and Y would be AAA-rated. The shape of the yield curve will also affectthe value of the option RVx,but it will not change the sign or the direction of the adjustment. When the yield curve slopes upward, the option to receive fixed (at the original coupon level) is worth less than the option to pay fixed, because forwardrates are higher than current rates. The adjustment to receive fixed is thus relativelylow. When the yield curve is positive, the expected losses from default on a par swap are not symmetric. To the degree that PYexceeds 0, the steeper the curve, the higher the risk exposure in paying fixed and the lower the risk exposure in receiving fixed.10 With a steep yield curve, the AAA-ratedswap party that is paying fixed and receiving floating should value the option to pay fixed more than it would value the option to receive fixed. In both cases (paying or receiving), the AAA-ratedpartyis exposed to the risk that its option (to pay or receive) will be lost in the event of default. If the counterpartydefaults, it will lose a more valuable

/ Financial AnalystsJournal May-June 1994

27

option if paying fixed in a steep curve environment, because the stochastic forward rates are likely to rise, making the swap an asset (as opposed to a liability). In general, when rates are expected to rise, the value of CRxwill be larger if paying fixed as opposed to receiving fixed. If paying fixed, the AAA-ratedparty should be compensated by paying a rate lower than the midmarket swap rate. There are at least two ways to think about the downward coupon adjustment when the curve is positively sloped. At first, the payer of fixed is paying more than it is receiving. It is compensated by the expectation that the floating rate will rise according to the forward rates embedded in the term structure. But the presence of default risk implies that the payer of fixed may not receive the later floating payments. Upon default, the higher floating rates will not be paid, hence cannot compensate the payer of fixed for the higher fixed coupon it paid earlier. A lower fixed coupon will compensate for this risk. Alternatively, the presence of default risk effectively means that the "expected maturity" is less than the term of the swap. If the swap were priced for the "expected maturity," the fixed rate would be lower because of the upward-sloping term structure. Both ways of looking at the risk lead to the conclusion that the fixed coupon should drop if the yield curve is positively sloped. Thus paying fixed is a valuable option that the AAArated party has exposed to the default risk of the lower-rated party. It follows that when the yield curve is flat, the value of the option to receive fixed (at the original coupon level) is the same as the value of the option to pay fixed, because forwardrates are the same as currentrates. When the yield curve is inverted, the option to receive fixed (at the original coupon level) is worth more than the option to pay fixed, because forwardrates are lower than currentrates. When might the unilateral default model fail to accommodateboth parties?An interesting situation arises when X and Y both have low but equal credit. Assume, for example, that X and Y are both BBB. X, looking at Y's credit quality, will want either to pay a lower fixed or receive a higher fixed. (The shape of the curve will affect the magnitude of the adjustment, but not the direction.) Y, however, will want an equal but opposite adjustment. As a result, the transaction will be precluded. A bilateralapproach could rectify this impasse. In summary, the unilateralapproachis highly relevant if (1) only one party has default risk or (2)

only one party has potential for a positive replacement value. With unilateraldefault risk, the credit of the counterparty and the shape of the yield curve affect the size of the adjustment for default risk, but not its direction. Furthermore,counterparties may not agree on the direction of the adjustment, let alone the magnitude. This would preclude a transaction.

BILATERAL DEFAULT RISK

In practice, default risk is often a two-way proposition in the case of swap contracts.If either of the two dimensions of replacement cost valuation affects both parties, then the valuation model should be adjusted to accommodate a two-way analysis. For example, both parties may be rated below AAA. In addition, the initial swap rate in a par swap and the future term structure paths will probablyinclude regions of net asset value as well as net liabilityvalue for each counterparty. In theory, one model may be applied to both parties. In reality, however, the parties may not agree on the parametersof the model or even the model specification. Specifically, if the parties do not have perfect information about each other's credit, frictions may arise. Use of an unbiased bilateralapproachmay reduce the size of the credit risk adjustment comparedwith the amount calculated under a unilateral approach. However, one or both parties may not agree to the coupon rate established by the model. To build a bilateralcredit model, assume that market frictions are minimal in that party X and counterparty Y agree on the parameters of the default risk model. Both parties have option positions that will create risk in both directions. Both parties have credit risk, and their options have future regions of both asset value and liability value. Party X estimates the required credit risk as:
CRX =Py RVx- PX . RVy

(2)

The probabilityof Y defaultingis multipliedby the option to replace the swap from X's point of view. Offsetting this is the probability of X defaulting multiplied by the option to replace the swap from Y's point of view. Central to the bilateral framework is the idea of the second term being offset against the first. The credit risk from Y's point of view is obtained by interchangingX and Y:
CRy= Px
.

RVy - Py

RVx

(3)

Note that:
= CRy - CRy

(4)

28

FinancialAnalysts Joumal I May-June 1994

The symmetry inherent in each party's being able to offset its own possibility of default against the other's guarantees that both parties will agree on the required adjustment to midmarketlevels. This fact is very important. Essentially, Expression 4 holds because both sides use the same bilateral approach. Transactionsthat would otherwise have been precluded may thus clear. The direction of midmarket adjustment of CR (from X's perspective) depends on which term in Equation 2 is larger. Each term is the product of a probabilityand an option value. If the first term is larger, then CRxwill be greater than 0, and X will receive a higher fixed coupon or pay a lower fixed coupon. If the second term is larger, then CRxwill be less than 0, and X will receive a lower fixed coupon or pay a higher fixed coupon. Because CRY equals -CRy, Y's adjustment is equal but opposite to that of X, and Y will always reach the same conclusion. For instance, if CRX exceeds 0, X will want to receive higher coupon. Similarly,because a is CRY less than 0, Y will be willing to pay a higher coupon. To appreciate Equation2 more fully, consider the special cases discussed below.

A FlatYieldCurve
When the yield curve is flat, the option to receive (the original) fixed coupon is equal to the option to pay (the original) fixed coupon: RVx = RVY= RV. The expression for CRxfrom X's point of view therefore becomes the following:
CRX= (Py- PX) * RV. (S)

costs (ratherthan on their credit ratings), which in turn depends on the shape of the yield curve. This was not the case with the unilateral model, in which the shape of the yield curve did not affect the direction of the adjustment. If the yield curve slopes upward, then the option to receive fixed (at the original coupon level) is worth less than the option to pay fixed (for the reasons given above). If X is receiving fixed, then RVX less than RVY,and CRxis less than 0; is therefore, the coupon that X receives will be lower than the midmarket rate. Similarly, if X is paying fixed, then RVXis greater than RVY, and CRx exceeds 0; therefore, the coupon that X pays will (again) be lower. (If the yield curve were inverted, the coupon would be higher than midmarket.) Note that when the credit conditions of the two parties are equal, the adjustment to the coupon does not depend on whether a party is paying or receiving. This is why both sides can agree to the adjustment. We can estimate the default risk model under a variety of parametersto determine the theoretical adjustment in coupon relative to the midmarket rate. Figure B shows the general direction and potential magnitude of the adjustments for varying swap party credit ratings and varying yield curve configurations.
Figure B. Sample Default Risk Adjustments for Varying Yield Curve Slopes and Varying Credit Ratings (A-ratedcounterpartypays fixed)
15 10 5

The size of the adjustment depends on the option value. However, the direction of the adjustment does not depend on the option (RV), because the option can only be positive. The direction of the adjustment depends on the differencebetween the credit ratings of the two swap parties. If Y has lower credit than X, then PYwill exceed Px, and CRXwill exceed 0; therefore, X will pay a lower fixed coupon or receive a higher fixed coupon. If Y has higher credit than X, then PYwill be less than will be less than 0, in which case X will Px' and CRX pay a higher fixed coupon or receive a lower fixed coupon.

00
-10 _ -15 -20 1 AAA

=..

.,.

AA

l A Inverted Curve Flat Curve Steep Curve

BBB

BB

- --

EqualCredits
When the credit conditions of the two swap
parties are equal, Py = Px = P. The expression for

....

CR from X's point of view therefore becomes:

= CRX P* (RVx- RVy).

(6)

Now the direction of the adjustment depends on the difference between the two parties' option

Table 1 outlines the bilateral credit adjustments for default risk under three yield curve and four credit-ratingconfigurations. The three curves in FigureB depict the coupon adjustment when an A-rated party pays fixed. Note first that the coupon will be higher, the higher the rating of the

Financial Analysts Journal / May-June 1994

29

Table 1.

Bilteral ModelSummary to couponrelative midmarket (adjusted swap levelfromX's pointof view)

Y and X Equalbut Less Than AAA Same Lower Higher Y Better Credit Than X Higher Either Higher Y Lesser Credit Than X Lower Lower

Y and X AAA X Pays Fixed Flat curve Upward sloping curve Downward sloping curve X Receives Fixed Flat curve Upward sloping curve Downward sloping curve Same Same

Same

Either

Same Same Same

Same Lower Higher

Lower Lower Either

Higher Either Higher

counterparty.Given the parametersused in these calculations, the A-rated party will pay an AAArated counterparty a coupon that is 10 to 15 basis points higher than the coupon it would pay to a BB-ratedentity.1' Second, note that the steeper the yield curve, the lower the fixed coupon rate. In a steep yield curve environment, the option position for the payer of fixed is greater in value than the option position for the receiverof fixed. The payer of fixed has a more valuable option and is compensated by paying a lower fixed rate. In this particularexample, we can see that when both partiesare A-rated, there is no adjustment to midmarketif the curve is flat. In this example, the difference between a steep curve and an inverted curve amounts to an adjustment of 10 tol5 basis points. If Figure B had shown the coupon adjustment fixed, then the curves an A-ratedparty receiving for from the lower left to would have sloped upward the upper right. The A-ratedparty would receive a lower-than-midmarket rate from an AAA-rated party for most yield curve shapes. Similarly, the A-rated party would receive a higher-than-midor marketrate from a BBB-rated BB-ratedcounterparty for most yield curve shapes. The middle line in Figure B (flat curve) would merely reflect a reversal in sign, passing through zero for an A-rated party receiving fixed from an A-rated party.

The General Case The midmarketadjustment generally requires a simultaneous evaluation of both terms in Equation 2, as the credit ratings of the companies and the shape of the yield curve interact. In general, when the curve is positive, the credit quality of the receiver of fixed will be most important. In an inverted curve environment, the credit quality of the payer of fixed will dominate the analysis. Note the interesting case in which X is receiving fixed from a counterparty, Y, with a lower credit rating and the yield curve slopes upward. On the one hand, X will require a higher coupon from Y to compensate for its lower credit. On the other hand, X will be willing to take a lower coupon from Y because of the positively sloped yield curve. Which factor dominates depends on their relative magnitudes. The unilateral model does not exhibit this type of behavior. This is evident in the example in which an A-rated party pays a below-midmarketcoupon to an AA-rated party when the curve is steep (see Figure B). For the general case-unequal credit ratings and an arbitraryyield curve-Equation 2 can be rewritten in a useful form. Define the average probabilityof default as:
AP= (Py+ Px)I2. (7)

FromX's point of view, the incrementalprobability of Y defaulting is:

IP = (Py- Px).

(8)

Eachprobabilitycan then be written in terms of AP and IP:

Px= AP - IP12

(9)

Py=AP+ IP12

(10)

Substituting Equations 9 and 10 into Equation 2 produces: (11) CRx= AP(RVX- RVy) + IP(RVx+ RVy)/2 Equation 11 separates the impacts of volatility, yield curve shape and credit quality on credit risk. The total credit risk adjustment is the sum of two terms-the average credit multiplied by the difference in options and the incremental credit multiplied by the average of the options. Now, the difference in the options is not a function of volatility, because changes in volatility cause both options to increase by equal amounts. Changes in volatilitythus have no net impact on the pricing of credit risk when the credit ratings are equal (IP = 0). Effectively, if credit ratings are equal, the

30

FinancialAnalysts Joumal / May-June 1994

volatility exposure of one party is offset by the volatility exposure of its counterparty. If an increase in volatilityincreasesthe potentialcreditrisk posed by one party, it increasesthe potentialcredit riskposed by the counterparty the same amount. by Conversely, if party Y is riskierthan counterpartyX, IP will exceed 0 and an increasein interest ratevolatilitywill increasethe sum of RVxand RVY, necessitatinga largercreditrisk adjustmentin favor of X. When credit ratings differ, the higher-rated party is exposed to more incrementalreplacement risk for any increasein interestratevolatility. While the second term in Equation11 captures interest rate volatility, the first term reflects sensitivity to yield curve shape (as discussed after Equation 6). To summarize, Equation 11 can be written in words as follows:
Average Credit x YieldCurveShape
CRx= +

UNILATERAL BILATERAL VERSUS

Unilateral credit analysis makes sense in some situations. Suppose you are paying fixed in a swap, and interest rates have risen substantially. This means that the swap has moved in your favor, and a closeout would involve a payment from your counterpartyto you. Because the counterpartyowes you money, you might be concerned about the abilityto pay. If there is little chance that swap rates will fall below the contractualrate, the swap will be more like a loan than a swap. In this situation, the counterparty'scredit is very important to you. At the same time, your credit is not importantto the counterparty.Consequently, it is perfectly reasonableto use a unilateralmodel that focuses on your counterparty's credit conditions and ignores your own. Of course, if rates have moved down and you are paying fixed at a high market rate, you effectively owe your counterparty.You would have to make a positive payment to close out the swap. In this case, your counterpartywould be more concerned about your credit, so a unilateral credit analysis from the counterparty's point of view makes sense. A more interesting situation arises when the swap is not in either party's favor. This is what typically happens when the swap rate is set at marketrates. Neither party knows in whose favor the swap may move, hence it is not clear from whose point of view the unilateralanalysis should be performed. In fact, if each party uses its own unilateral analysis, the two parties will probably never agree to a swap rate. In this situation, it makes more sense to use a bilateralanalysis, in which each party takes into account the other's credit. There are two requirements for a robust analysis. First, the analysis should be symmetric-that is, both sides should agree about the results. Second, when rates have moved substantially (that is, when the credit exposure is significantlyone-way), the results should approximatethose from a unilateralanalysis.

Differential Credit x Volatility.

Note that when the yield curve is flat, the term for the shape of the yield curve is zero, and when the counterparties are of equal credit, the term for differencesin credit ratings is zero. In summary: * For any yield curve, no credit risk adjustment is necessary if both partiesare rated AAA. * No credit risk adjustment is necessary if the yield curve is flat and both parties have the same credit rating. * If both parties have the same credit rating, the credit risk adjustment (hence the coupon) is the same regardless of who pays fixed and regardlessof the yield curve's shape. * If the yield curve slopes upward, the fixed coupon (paid or received) should be lowered. * If the yield curve slopes downward, the fixed coupon (paid or received) should be raised. * If the party paying fixed is of a higher credit rating than the party receiving, the fixed coupon should be lowered. * If the party paying fixed is of a lower credit quality than the party receiving, the fixed coupon should be raised. * The shape of the yield curve may sometimes offset differences between the swap parties' credit ratings;the adjustment to the midmarket coupon level can then be positive or negative.

CONCLUSION
The pricing of default risk in a swap revolves around the replacementcosts and swap settlement rules. We have focused on the payoff asymmetry in the event of default. In effect, one swap party is short an option to receive (pay) fixed and long an option to pay (receive) fixed, while the counterparty simultaneously owns the opposite pair of options. The values of these options will have an impact on fixed-coupon swap rates. Their prices

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will depend on a number of factors-the swap parties' default probabilities,interest rate volatility and the term structureof interest rates. Default risk can be priced via a unilateral (one-way) analysis if only one party has default risk; otherwise, it is myopic to focus on only one

party's default probability. If both parties have default risk, then a bilateralview is more appropriate. The bilateral approach, although theoretically more accurate,may be difficultto implement because of frictions and information asymmetries between the participants.12

FOOTNOTES
1. For example, see K. Brown and D. Smith, "Default Risk and Innovationsin Design of InterestRate Swaps," FinanSummer1993,and I. Cooperand A. Mello, cialManagement, of "Default Risk of Interest Rate Swaps," Journal Finance, June 1991. 2. In this analysis, we assume that the InternationalSwap Dealers' Association (ISDA) Master Agreement between counterparties reflects "full two-way payments." As a tend to view swap general rule, in practice,counterparties defaults as creating a potential payment by the solvent counterpartywhen the swap represents a liabilityfor the intersolvent counterparty.A typicalfixed-for-floating-rate est rate swap has many possible default periods and an uncertain replacement cost at each period. At each reset defaults, date, we must ask the following:If a counterparty what will the replacementcost be for the solvent counterparty?It will make a differencewhether interestrates have risen, fallen or remainedthe same. If the fixed rate for the remainingterm is the same as the originalfixed rate, then the value of the swap is par on the interest reset datesand the replacementcost to the solvent party is at or near zero. However, if interest rates have changed to favor the solvent counterparty (rates rising when paying fixed or rates falling when receiving fixed), there is a replacement cost. Whetherthe floating rate has risen or fallen does not affect the replacement value of the swap on reset dates; however, it does have a small impact in between reset dates. What are the likely termination flows in the event of default?Whatare the payments that are likely to take place if one party suspends payments?The rules governing the actual payments are established by the contract entered into between the parties. Typically, the parties will enter into an ISDA MasterAgreement. The ISDA MasterAgreement is intended to be used as a single contractgoverning multiple swaps between the parties. Under the ISDAMaster, there are two methods for determining settlement payments following an event of default. The ISDA Master Agreementallows the partiesto elect the paymentmeasure value replacement based on eithermarket quotations (current of transaction) loss (totalloss to "in-the-money" or party). The standardmethod providedby the MasterAgreement The requires"netting"of all outstandingswap transactions. of Master Agreementallowsthe partiesto electvaluation each swap at currentmarketrates. valueof eachswap mustbe determined by First,the market pricinga new swap contractat the currentswap rates. The nondefaultingparty solicitsa set of quotationsfrom leading dealersin the relevantmarketthatestablishesa current swap rate that would apply if the defaultedswap is replaced.The defaulted swap value comparedwith a replacementswap may be positive or negative, depending on the level of interestratesat the time of the default. Second,the replacement swap valuesof all swaps between the parties,whetherpositiveor negative,areaddedtogether. The net amount,whetherpositiveor negative,is then added to any accruedbut unpaidinterestpaymentsdue and owing on the termination date. The amount due and owing to the defaultingpartyis then subtracted from this total. The net amount,if a positivenumber,is to be paid by the defaulting party.In the casewherethe net amountis a negativenumber, the absolutevalueof thatamountis paidby the nondefaulting party. The MasterAgreementallows the partiesto elect between two payment methods-"limited two-way payments"and "full two-way payments,"which most partieselect. Under full two-way payments, either party may be liableto pay a fixednet due amount-even the nondefaulting counterparty. Whatdetermines which partyis liableto pay a termination value for each swap?If swap rateshave risen, the receiver of fixedwill owe a payment.Conversely, rateshave fallen,the if payer of fixed will owe a payment. The payment due is irrespectiveof which party actuallydefaults. This problem may be compounded when one party is insolvent. If an insolvent party owes a payment, the solvent party will become a general uncollateralized claimantand may have to forfeitthe entireasset value. Thus the termination value that is determined the swap dealers'quotationsfor each swap by shouldbe the difference betweenparand a swap pricedat the prevailingswap rates. This is directlyrelatedto the degree that the swap is in-the-moneyfor one party(and out-of-themoney for the counterparty). In general, there are three dimensions that affect the nondefaultingpartyin the presenceof defaultrisk-(1) the event of default (yes or no); (2) the stochasticbehaviorof interestrates;and (3) the recoveryratioon unsecureddaims on the defaultingcounterparty. Below is a matrixof possible for economicconsequences the receiver fixedin an interest of rateswap. Consequences of Default for the Solvent Counterparty That is the Receiver of Fixed No Default Interest Rates Up Interest Rates Down Unrealized Liability Unrealized Asset Default/Partial Recovery Mark-to-Market Liability ForfeitPart of Asset Value

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FinancialAnalysts Journal / May-June 1994

3.

4. 5. 6. 7. 8.

Effectively,the MasterAgreementprovides that in default, the receiverof fixed will be adverselyaffectedby any rise or fall in interest rates. Either the liabilitywill be marked to market and that party makes a payment in settlement, or the asset value will be lost in replacingthe swap at current marketrates. The same is true if such counterpartyis the payer of fixed. The matrix above holds for the payer of fixed, except that the interest rate directionsare reversed. Asymmetry surroundinga default exists because the nondefaultingparty may not receive a full payment, especially if the defaultingpartyis insolvent. At the same time, it may owe a payment as a consequence of settlement. Sun, Sundaresanand Wang report that the typical spread between midmarketswap bid and offer rates ranges from 10 to 15 basis points. See T.-S. Sun, S. Sundaresanand C. Wang, "InterestRate Swaps. An Empirical Investigation," Journal Financial of Economics (1993),77-99. 34 Partiesset markingfrequenciesand call thresholdsdepending on the level of expected volatility. DVO1refers to the price sensitivity for a swap to a onebasis-pointmove in the referenceyield. Multiple dates for default are obviously more realistic.A single date allows the component options to be described individually. Party Y might apply a unilateralmodel to X and would arriveat a differentadjustment, Px x RVY It may be the case that the loss is only a partialforfeiture

because the insolvent counterpartymakes some payment. Withoutloss of generality,we assume that the totalimpact of default is incorporatedinto one number, RV. 9. Forexample, a model may dictatethat under these extreme circumstancesX requires a 40 to 50-basis-pointupward adjustmentin the 10%coupon for the remaininglife of the swap. 10. In an interestrateenvironmentsuch as 1992-93(very steep curve), a risky customer of an AAA dealer should expect quotes close to but above midmarket paying fixed and a for downward-adjusted spread under midmarketfor receiving fixed. 11. Figure B is an illustration of the general nature of the defaultpricing.The precisecalculationswill vary according to market conditions and estimated default probabilities. For example, with higher interest rate volatility and/or wider qualityspreads in the bond market,these estimates will increase. 12. Although the informationin this work has been obtained from sources that Salomon Brothers Inc believes to be reliable,we do not guaranteeits accuracy,and such information may be incompleteor condensed. All opinions and estimatesincluded in this work constituteour judgmentas of this date and are subjectto change without notice. This work is for informationpurposes only and is not intended as an offer or solicitationwith respect to the purchase or sale of any security.

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