CFA Level II ExamDerivativesMedium
A risk manager is evaluating the credit risk associated with an interest rate swap. The swap has a notional principal of $50,000,000. Counterparty A is the fixed-rate payer and Counterparty B is the floating-rate payer. If interest rates unexpectedly increase significantly, which counterparty faces positive credit risk (i.e., would suffer a loss if the other counterparty defaulted)?
- ABoth counterparties equally
- BCounterparty A (fixed-rate payer)
- CCounterparty B (floating-rate payer)
- DNeither counterparty, as credit risk is zero for interest rate swaps
Show answer & explanationAnswer & explanation
Correct answer: B. Counterparty A (fixed-rate payer)
If interest rates increase significantly, the value of the floating-rate payments will increase relative to the fixed-rate payments. This makes the floating leg more valuable. Therefore, the fixed-rate payer (Counterparty A) would be 'in the money' and would face a loss if the floating-rate payer (Counterparty B) defaulted.
Why the other options are wrong
- A. Incorrect. Credit risk is not necessarily equal; it depends on the direction of interest rate movements.
- C. Incorrect. The floating-rate payer would be 'out of the money' if rates increase, meaning the swap has negative value to them, and they would not suffer a loss if the fixed-rate payer defaulted.
- D. Incorrect. Interest rate swaps, like other derivatives, carry counterparty credit risk.
Interest Rate Swap Credit Risk
Credit risk in an interest rate swap arises when one counterparty's position becomes 'in-the-money' (has positive value) and the other counterparty defaults.
- The 'in-the-money' party faces a loss equal to the positive value of the swap if the 'out-of-the-money' party defaults.
- Interest rate movements determine which party is 'in-the-money'.
- For a fixed-rate payer, rising rates generally create positive value; for a floating-rate payer, falling rates generally create positive value.
Memory trick: Credit Risk: Who's 'Winning' if the Other Guy 'Quits'?