A portfolio manager holds a bond with a value of $1,000,000 and wants to convert its interest rate exposure from fixed to floating. The manager enters into a plain vanilla interest rate swap where they pay a fixed rate and receive a floating rate. The current fixed rate for a 5-year swap is 4.00%, and the floating rate is 6-month LIBOR. The manager is concerned about the credit risk of the counterparty. Which of the following best describes the credit risk exposure of the manager in this swap?
- AThe manager is exposed to credit risk only if interest rates decrease significantly.
- BThe manager is never exposed to credit risk due to netting agreements in swaps.
- CThe manager is exposed to credit risk only if interest rates increase significantly.
- DThe manager is always exposed to credit risk, regardless of interest rate movements.
Show answer & explanationAnswer & explanation
Correct answer: A. The manager is exposed to credit risk only if interest rates decrease significantly.
In a pay-fixed, receive-floating interest rate swap, the fixed-rate payer benefits if interest rates decrease, as the value of the floating payments they receive will decrease, but the fixed payments they make remain constant. The counterparty (fixed-rate receiver) would then owe the manager money, making the manager exposed to the counterparty's credit risk. If interest rates increase, the manager (fixed-rate payer) would owe money to the counterparty, making the counterparty exposed to the manager's credit risk. Therefore, the manager is exposed to credit risk if interest rates decrease significantly, making the swap valuable to the manager.
Why the other options are wrong
- B. Incorrect. While netting agreements reduce exposure, they don't eliminate it completely, especially if the counterparty defaults and the netting agreement is not fully enforceable.
- C. Incorrect. If interest rates increase, the manager (fixed-rate payer) would owe the counterparty, so the counterparty would face the manager's credit risk.
- D. Incorrect. The direction of credit exposure depends on the movement of interest rates and which party is in-the-money.
Interest Rate Swap Credit Risk
The risk that a counterparty to an interest rate swap will default on its obligations, leading to financial loss for the non-defaulting party.
- Credit risk in swaps is bilateral, meaning both parties face it.
- The party 'in-the-money' (the one owed money) faces the credit risk of the counterparty.
- For a pay-fixed, receive-floating swap, the fixed-rate payer faces credit risk if rates decrease.
Memory trick: Who's Owed, Who's Risky.