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The Valuation of Interest Rate Swap with Bilateral Counterparty Risk

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  • Tim Xiao

    (University of Toronto)

Abstract

This paper presents an analytical model for valuing interest rate swaps, subject to bilateral counterparty credit risk. The counterparty defaults are modeled by the reduced-form model as the first jump of a time-inhomogeneous Poisson process. All quantities modeled are market-observable. The closed-form solution gives us a better understanding of the impact of the credit asymmetry on swap value, credit value adjustment, swap rate and swap spread.

Suggested Citation

  • Tim Xiao, 2019. "The Valuation of Interest Rate Swap with Bilateral Counterparty Risk," Working Papers hal-02169144, HAL.
    • Handle: RePEc:hal:wpaper:hal-02169144
    Note: View the original document on HAL open archive server: https://hal.science/hal-02169144
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    Keywords

    defaultable interest rate swap; bilateral defaultable claim; credit asymmetry; market models; Black model; LIBOR market model; reduced-form model; credit value adjustment; swap spread;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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