Counterparty Credit Risk in Interest Rate Swaps

Counterparty Credit Risk in Interest Rate Swaps during Times of Market Stress Antulio N. Bom m Federal Reserve Board First Draft: September 27, 2002 This Draft: December 17, 2002 Abstract This paper examines whether empirical and theoretical results suggesting a relatively small role for counterparty credit risk in the determination of interest rate swap rates hold during periods of stress in the financial markets, such as the chain of events that followed the Russian default crisis of 1998. The analysis sheds light on the robustness of netting and credit enhancement mechanisms, which are common in interest rate swaps, to widespread turmoil in the financial markets. JEL Classication: G12, G13 Keywords: convexity adjustment, futures and forward rates,

a ne models Board of Governors of the Federal Reserve System, Washington, DC 20551; E-mail: abom m@frb.gov; Fax: (202) 452-2301, Tel.: (202) 736-5619. I am grateful to Je Dewynne and Pat White for helpful comments, to Emily Cauble and Joseph Rosenberg for excellent research assistance, and to seminar participants at the Federal Reserve Board for their insights. The opinions expressed in this paper are not necessarily shared by the Board of Governors of the Federal Reserve System or any other members of its sta . 1 Introduction Spreads of rates on interest rate swaps over comparable U.S. Treasury yields widened dramatically during the acute nancial market turmoil that followed the Russian default crisis of 1998 (Figure 1). While a signi cant portion of that widening in swap spreads likely reflected increased concerns about credit risk in general and greater demand by investors for the safety and liquidity of Treasury securities|corporate bond and LIBOR spreads over Treasuries had also moved substantially higher|it is conceivable that swap spreads were also affected by market participants’ worries about counterparty credit risk in swaps. This paper examines a well-known no-arbitrage relationship between interest rate swaps and eurodollar futures contracts to take a novel look at this issue. In particular, I examine whether the spread between swap rates quoted by dealers and synthetic" swap rates implied by the futures market| where counterparty credit risk is virtually absent|provided any indication that swap rates were signaling heightened concerns about counterparty risk in the swaps market at that time. Understanding the potential role that concerns about counterparty credit risk play in the pricing of interest rate swaps during times of nancial market stress is important for at least two reasons. First, while a vast academic literature has studied the issue both from a theoretical and an empirical per- spective, existing studies have not assessed the robustness of their fundings to episodes of turmoil in the financial markets. Second, the interest swap market has been increasingly taking on a benchmark role in the broader xed- income market that had previously virtually been the exclusive domain of U.S. Treasury debt securities. Given its greater prominence for the financial markets as a whole, the question of assessing the ability of the swaps mar- ket to continue to function without major impediments|such as heightened concerns about counterparty credit risk|when other (less liquid) markets are disrupted gains special significance for...

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