Potential credit exposure on interest rate swaps

An analytical analogue to the Monte Carlo techniques previously used by banking supervisors to assess the potential credit exposure of interest rate swaps is developed, which permits a more thorough examination of swap exposure. This is done by using the Cox, Ingersoll and Ross (1985) one-factor model of the yield curve to generate interest rate paths from which swap credit exposure paths can be determined. Even with such a relatively simple interest rate process, the patterns of credit exposure are found to be more complex than the supervisors previous techniques allow: they vary with the level of interest rates, the slope of the yield curve and the volatility of the short rate - all factors which are ignored in the supervisors risk measurement methodology - and have a significantly non-linear relationship with swap maturity. In conclusion, market traders and regulators need to be alert to these factors in determining the appropriate level of capital to hold as protection against counterparty default.