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

The key point is that it is the imbalance in degrees of credit risk between the counterparties that motivates the adjustment in the fixed rate on the swap or the request for collateral (or letter of credit). Given that each counterparty must assess its default risk exposure to the other, neither would be very willing to give up something in the agreement without getting the same in return. So, collateral is used in the swap market mostly to equalize a disparity in the creditworthiness of the counterparties, not to manage the inevitable exposure that arises even between two comparable firms.(3) Mutual exchange of collateral presents the problem of retrieving the securities that had been posted if the counterparty were to default on the swap, especially if those securities had been lent out in the "repo" market. An alternative would be to post collateral with a third party acting as a clearinghouse. The value of securities to be posted could be a fraction of the notional principal or the market value of swap. In any case, the use of collateral raises transactions costs in the same manner as the margin account on an exchange-traded futures contract.

Because of the bilateral nature of potential credit risk, swaps are negotiated on a more "level playing field" than typically encountered with bank loan contracts. That, in turn, also limits the ability of both parties to demand restrictive covenants. However, there are two such items that usually are contained in swap documentation. The first is a cross-default clause which triggers the swap's default in the event that any indebtedness of one of the counterparties is either in default or has been accelerated. This provision mitigates the effects of what we describe below as a default-timing option. Second, swap agreements also often require that multiple contracts between the same counterparties be netted against each other, which eliminates the ability of the defaulting party to "cherry-pick" contracts -- i.e., default on only those with negative economic value while maintaining the ones with positive value. To guarantee that provisions such as these are adopted, market makers prefer that customers sign a master swap agreement to expedite future transactions and ensure that all existing swap positions can be netted out if a default were to occur.

A default-timing option can arise if the defaulting party can benefit by postponing the event of default itself. Suppose that the economic value of the swap, as measured by Equation (1), is negative but the firm is scheduled to receive a payment at the next settlement date. For example, assume Firm B is in serious financial distress at a time when [F.sub.0, N] [is greater than] [F.sub.-T, N T] and [I.sub.0] [is less than] [F.sub.-T, N T]. This means that the existing receive-fixed rate is below-market even though the next scheduled settlement provides a net cash inflow. This could occur if the yield curve dramatically steepened after the swap was originated, driving the short-term index rate down and the longer-term fixed rate up. Firm B clearly would have no reason to default on the swap prior to the next receipt. In general, it would have an incentive to defer defaulting on the swap as long as the floating-rate index calls for net cash inflows. Moreover, all creditors of Firm B would concur with the decision to defer default until a time when [F.sub.0, N] [is greater than] [F.sub.-T, N T] and [I.sub.0] [is greater than] [F.sub.-T, N T].(4) As noted, a cross-default clause works against such a default-timing option by identifying as events of default factors other than direct nonpayment of an owed amount on a settlement date; for instance, filing of bankruptcy proceedings by any other creditor will also bring the swap into default, triggering termination of the agreement.