Swap Credit Risk and Swap Spread

  • Current Credit Risk: The situation where one swap party is owed a payment now and the other party cannot make the payment.

  • Potential Credit Risk: The possibility that the other party may default in the future.

  • The amount at risk for default is equal to the swap's market value at any given point in time.

  • While swaps are over the counter, the parties can agree to a marking to market method for controlling credit risk.

  • Swap spread is the difference between a swap's fixed rate and an equal maturity risk free rate, such as the yield on government debt with a same maturity.

  • Swap rates can be quoted as a spread over equivalent risk free rates; this spread can be interpreted as a gauge of credit risk in the general market.

  • During times of economic turmoil, swap spreads tend to widen.

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