DEFAULT RISK AND INNOVATIONS IN THE DESIGN OF INTEREST-RATE SWAPS

The emergence of an active interest rate swap market has transformed t he nature of corporate debt issuance and risk management. Many firms n owadays routinely use swaps to adjust their ratio of fixed to floating rate debt when there is a change in management's view on interest rat es. For instance, if it is felt that market rates have bottomed, a fir m could raise that ratio by entering a swap to pay a fixed rate and re ceive the prevailing level of some reference rate, such as LIBOR (Lond on Interbank Offer Rate). There is, however, default risk on the swap. In this example, the risk is that the counterparty defaults when the fixed rate on a replacement swap is higher than the one originally con tracted. Potential default risk at origination is bilateral in that ea ch party to the agreement must consider the riskiness of the other. At any point in the lifetime of the swap, the actual default risk is uni lateral in that the swap would have positive economic value to only on e of its counterparties. If the potential default risk on a swap is vi ewed as prohibitive, the firm might be able to use exchange-traded fut ures contracts to accomplish its risk management objective. With futur es, daily mark-to-market valuation and settlement effectively limit th e credit risk to one day's price movement. However, the number of futu re delivery dates is typically limited, so rolling over a series of fu tures contracts might simply result in a trade-off of less default ris k for more price (or basis) risk. An alternative is to redesign the st andard interest rate swap contract to reduce the inherent default risk . In this article, we consider two innovations to swap design: mark-to -market swaps and forward rate swaps. A mark-to-market swap requires t hat the fixed rate be reset periodically to reflect any change in mark et rates. In effect, on each scheduled settlement date, the swap is cl osed out, generating a payoff to the counterparty for which the swap h as taken on positive value. Then the swap is reestablished at the new fixed rate prevailing in the market at that time. This procedure limit s build-up of default risk to rate changes experienced within a settle ment period, typically three or six months. For example, suppose the f ixed rate on a three-year swap is eight percent. One year later, the f ixed rate on a two-year swap is nine percent. The fixed-receiver would pay the fixed-payer the current economic value of the contract, calcu lated as the present value of a two-year annuity of one percent (i.e., the difference in the old and new fixed rates) times the notional pri ncipal. That exchange would be in addition to the regular settlement p ayment determined by the difference between LIBOR and the fixed rate. Further, the swap would now have a fixed rate of nine percent for the remaining two years of the original maturity. This design reduces defa ult risk but can generate more unpredictability in period-to-period ca sh flows compared to the standard structure. Also, accounting and mana gement information systems might have to be developed to handle the se ttlement cash flows. Ultimately, the source of default risk on a swap is that firms do fall into financial distress and interest rates are r andom. But the design on a conventional swap usually exacerbates the e xtent of default risk by setting a uniform fixed rate applicable to al l settlement periods. Suppose that LIBOR is generally expected to be r ising and that the yield curve is upward-sloping. Then, the default ri sk to the payer of the fixed rate on a conventional swap would be ''ba ck-loaded'' in that the firm expects to be making net payments early i n the life of the swap and receiving payments later. Similarly, the de fault risk to the fixed-receiver would be ''front-loaded.'' A forward rate swap would set a sequence of fixed rates reflecting the expected path of LIBOR. In practice, this could be accomplished by using the se t of implied forward rates derived from the term structure. Notice tha t this design, as with plain vanilla swaps, allows the build-up of def ault risk over time, especially if the actual path of LIBOR diverges f rom the forward rate path. In fact, in some scenarios the default risk on this design could exceed the standard structure. Both innovations provide for varying fixed rates over the lifetime of the swap. The mar k-to-market design uses actual rates to make adjustments ex post; the forward rate design uses expected rates to make them ex ante. Both des igns can effectively transform floating-rate debt to a fixed-rate liab ility with a known, locked-in cost of funds over the time to maturity. With the forward rate design, the net interest payment would vary eac h period but would be known in advance; with the mark-to-market design , it would be uncertain. However, the mark-to-market scheme reduces th e default risk effectively and surely, the forward rate swap less prec isely and only to the extent that future rates follow the path structu red into the agreement. When default risk on conventional swaps is vie wed as prohibitive, these innovations offer possible alternatives.