Default Risk and Innovations in the Design of Interest Rate Swaps

 

Keith C. Brown

Donald J. Smith

 

Financial Management 22, 1993, pp. 94-105

 

 

Abstract

                       

This paper analyzes two design innovations to the structure of an interest rate swap intended to minimize financial loss if the counterparty to the agreement defaults.  First, we show how default risk exposure can be substantially reduced by periodic marking to market of the swap’s fixed rate.  Second, we demonstrate the mechanics of a ‘forward rate’ swap, which would have a time-varying fixed rate rather than a uniform rate for all settlement periods.  We develop numerical examples for each innovation and discuss practical considerations in implementing the designs.

 

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