How Counterparty Default Changes an Interest Rate Swap’s Value

Summary

The document asks how default affects the nondefaulting party in a plain interest rate swap. Party A pays floating and receives fixed from B; if A defaults, the question is why B’s position appears to benefit when rates rise but not when rates fall. It probes whether settlement depends on the direction of rate changes or on the rules governing claims against the bankruptcy estate.

The discussion is a question about swap valuation and default closeout, rather than a worked explanation. It introduces the asymmetry between a positive replacement value owed to B and a negative value B might owe when the swap is out of the money. The text provides no resolution, legal mechanics, calculations, or supporting evidence, so it does not establish how a particular contract or bankruptcy process handles settlement. Any practical conclusion would depend on the applicable closeout and insolvency rules.

Key ideas

• A swap’s value to a party changes as market interest rates move relative to the contract’s fixed rate.
• The question concerns how default affects positive and negative swap replacement values.
• It raises the possibility that claims owed by the nondefaulting party are treated differently in bankruptcy.
• The document offers no answer, and settlement treatment depends on contract terms and applicable insolvency rules.

Tags

# What makes the benefit of defaulted counterparty risk asymmetric in an interest swap?


# What makes the benefit of defaulted counterparty risk asymmetric in an interest swap?












On page 369 of Quantitative Risk Management (2015) by McNeil, Frey, and Embrechts, there is an interesting example that I do not quite understand. Suppose A makes a floating interest rate payment to B, and B pays a fixed interest to A, but now A defaults. The book says:

> If interest rates have risen relative to their value at inception of the contract, the fixed interest payments have decreased in value so that the value of the swap contract has increased for B.

> On the other hand, if interest rates have fallen relative to their value at t = 0, the fixed payments have increased in value so that the swap has a negative value for B. At settlement, B will still have to pay the value of the contract into the bankruptcy pool, so that there is no upside for B in A’s default.

I am not quite familiar with the rules here, which seems to be the key. Does the words in bold mean, depending on which rate is higher, B pays differently? Alternatively, should the debt of a higher interest rate be paid first, just like the senior CDO trench?

Thank you for your time.

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