Default risk and innovations in the design of interest rate swaps - includes appendix - Security Design Special Issue

Financial Management (Financial Management Association), Summer, 1993 by Keith C. Brown, Donald J. Smith

In the past ten years, interest rate swaps have become one of the most popular and effective products available to financial managers for controlling the impact of changing financial market conditions. That they are widely used is indisputable. Abken [1], citing data obtained from the International Swap Dealers Association (ISDA), noted that by year-end 1989 the U.S. dollar portion of the swap market (as measured by outstanding notional principal) had grown to about $2.4 trillion on a worldwide basis. This expansion is truly remarkable when one realizes that the first single-currency interest rate swap was not transacted until 1982. Further, the pervasiveness of these commitments is equally impressive. For example, a recent survey of chief financial officers by Institutional Investor [5] showed that nearly three-quarters of the corporations with revenues of at least $3 billion have used swaps.

The explosive growth in the swap market over the past decade has masked one vital concern about these agreements. Simply put, though it is generally regarded as a tool for reducing interest rate risk, an interest rate swap is itself a risky transaction. Aggrawal [2] summarized the various types of exposure borne by the swap user, including risk due to unexpected changes in market prices and regulatory, legal, and accounting matters. But the most important of these risks is the potential economic loss that a firm would incur if its counterparty defaulted on the swap agreement when interest rates have moved adversely. Financial managers have now become aware of the default costs associated with using interest rate swaps, which, according to Cooper and Mello [6], are likely to be subordinate to debt claims in the event of bankruptcy. As an indication of this, the same Institutional Investor survey reported that roughly 80% of the CFOs responding expressed increasing concern over the creditworthiness of their swap partners, with over one-third of that group admitting to having actually rejected a potential counterparty because of this risk.

It is difficult to get accurate data on default losses in the swap market because many transactions apparently are worked out without technical default. Kapner and Marshall [9] reported results from a 1987-1988 ISDA survey indicating that only 11 of 71 swap dealers had experienced write-offs, amounting to just $33 million on aggregated portfolios at that time of $283 billion. While this figure suggests very low default rates, it pre- dates the court-ordered default on swap positions held by British local authorities (i.e., municipalities) whereby a number of bank counterparties stand to lose amounts estimated at (pounds)500 million on positions that reached a maximum notional principal of over [pounds]10 billion. In that case, the courts ruled that the local authorities had exceeded their legal power because the swap positions could not be justified as hedges and thus were considered outright speculation. Further, although a 1992 ISDA survey indicated that only about 0.5% of the outstanding notional principal over the last decade was lost to default, Glasgall and Javetski [7] noted that workouts were also needed to transfer positions involving the failed institutions, Bank of New England and Drexel Burnham Lambert, with the latter's swap book totaling over $30 billion.

There are two ways of viewing swap default risk: (i) actual exposure, which is a measure of the loss if the counterparty were to default and is based on the movement in swap market rates between the inception of the agreement and the current date; and (ii) potential exposure, which is based on a forecast of how market conditions might change between the present and the swap's maturity date, including in some manner the probability of default by the counterparty. Thus far, the academic literature investigating this topic has concentrated on estimating the value of potential exposure and showing how it is shared between the counterparties. Simons [11] demonstrated how many of the ad hoc estimation techniques used in practice could be improved by employing simulations of different future interest rate environments. This approach was generalized by Sundaresan [13] who assumed a stochastic process to characterize future interest rate movements in order to show how default risk impacts swap valuation. Cooper and Mello [6], in addition to producing a theoretical model for valuing potential default risk, examined the transfer of this risk between three groups associated with a firm: shareholders, debtholders, and the swap counterparty. While this focus on potential exposure is important, what remains largely unaddressed is the extent of the actual default risk that accumulates as a swap position seasons. The goal of the present research is to explore ways in which the structure of the swap agreement can be revised to reduce this type of exposure.

The analysis is organized as follows. In the first section, we develop an analytic framework to measure actual default exposure and discuss the market practices widely used to deal with that risk. Section II outlines the mechanics of the mark-to-market swap, the first of two design innovations we examine. We demonstrate that the mark-to-market swap agreement is essentially a sequence of swap commitments, each of which is liquidated after a single settlement period. A second design innovation, the forward rate swap, is introduced in Section III. In this approach, the usual swap structure is modified at the time of its origination by altering the pattern of fixed swap rates to reflect expectations about the market conditions that will prevail on the future settlement dates. Examples of both designs, along with a discussion of practical issues in their implementation, are presented in each respective section. In the final section, we offer some concluding comments.