The effect of systematic risk factors on counterparty default and credit risk of interest rate swaps

This research investigates the effect of specific systematic risk factors on credit risk pricing and capital allocation of interest rate swaps. Because of the stochastic nature of uncertain future cash flows and interest rates, practitioners typically employ the Black-Scholes option pricing model in...

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Bibliographic Details
Published in:Journal of economics and finance 2000-10, Vol.24 (3), p.215-231
Main Author: Volkman, David A.
Format: Article
Language:English
Subjects:
Credit risk
Interest rate swaps
Mathematical models
Risk factors
Shadow prices
Simulation
Studies
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Summary:This research investigates the effect of specific systematic risk factors on credit risk pricing and capital allocation of interest rate swaps. Because of the stochastic nature of uncertain future cash flows and interest rates, practitioners typically employ the Black-Scholes option pricing model in combination with a simulation analysis to establish capital requirements and estimate the shadow price of an interest rate swap. However, this practice of pricing swap risk excludes systematic risk factors that affect the risk shadow price, thereby underestimating the capital allocation required for financial institutions. This research demonstrates the effect of risk mispricing when simulations models ignore systematic risk factors such as model risk, convexity risk, and parameter risk on the pricing of interest rate swaps.
ISSN:1055-0925
1938-9744
DOI:10.1007/BF02752604