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I am kind of confused about how to approach the following question.

Suppose I enter into a interest rate swap (IRS) with counter party C. Details are : Fixed rate rate receiver, floating rate payer :C;

          Duration : 5 years,
          Coupon payments: quarterly,
          Notional Principal: 100 million
          Fixed Rate: 4% per annum quaterly basis.

Given the interest rates follows a normal distribution with mean standard deviation 10perecent; and 95 percent confidence interval.

What is the pre settlement risk of counterpart C at each payment date over the tenure, and plot the risk of 20 potential credit exposure.

Answer: Shouldn't all the payment from Counter party C should all be the same? I am not getting the concept or how to approach this question.

Thanks

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  • $\begingroup$ Initially the IRS will have value 0, but as interest rates change it will gradually acquire a value (positive for one counterparty and negative for the other, one party will have been proven right on his view of i.r. and the other will be proven wrong and regret the trade). The highest danger from default usually occurs somewhere in the middle of the term, when i.r. have moved substantially but the remaining duration is still substantial. At that point default by the 'loser' will be most damaging to the 'winner' in the game. The valuable IRS will vanish in an instant. $\endgroup$ – noob2 Mar 19 '17 at 21:24
  • $\begingroup$ In the example you are receiving the floating rate from counterparty C, if in $2\frac{1}{2}$ years floating rates are very high and C announces he is no longer paying you, your loss will be severe: you lose 10 big quarterly payments you were expecting. $\endgroup$ – noob2 Mar 19 '17 at 21:35
  • $\begingroup$ How to plot it? or something or answer it formally? Thank you $\endgroup$ – user2792941 Mar 19 '17 at 22:06
  • $\begingroup$ So how to calculate the pre settlement risk? Go over all the dates individually and find the worst cases for the counterparty? $\endgroup$ – user2792941 Mar 19 '17 at 22:07
  • $\begingroup$ Please Help someone? $\endgroup$ – user2792941 Mar 20 '17 at 5:42
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  1. Pre-Settlement (potential future exposure PFE) calculation at 20 payment dates:

    • assume a model for the floating interest rate: might be a constant across all maturities for simplicity (flat yield curve)
    • shift the yield curve to 95th percentile in your favor
    • calculate the price of the swap at each time point (remember that tenor of the swap shorten as you move forward) using the shifted yield curve

Alternatively: you can simulate interest-rate (yield curve) shifts for example 1k times using an interest-rate model and then take out 95th percentile of swap prices in your favor at each time point - this will be your PFE

  1. the shape of the credit risk profile for a generic swap is increasing to a maximum point ( this will be around duration/3 time point) and then decreasing to 0 but details depends on the yield curve shape: for a upward sloping yield curve you can expect to have negative cash-outflows in the second half of the contract tenor as your floating rate should be higher than fixed rate

The process for pre-settlement risk calculation can be found in the literature.

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