Default Risk and Innovations in
Design of Interest Rate
KeithC. Brownand DonaldJ. Smith
KeithC. Brownis an Associate Professorof Finance at the Universityof Texas,Austin,Texas,and
Donald J. Smithis an Associate Professorof Finance at Boston University,Boston, Massachusetts.
* In the past ten years, interestrate swaps have become
one of the most popularandeffective productsavailableto
financialmanagersfor controllingthe impactof changing
financialmarketconditions.That they are widely used is
indisputable.Abken [1], citing data obtained from the
InternationalSwapDealersAssociation(ISDA),notedthat
by year-end 1989 the U.S. dollar portion of the swap
market (as measuredby outstandingnotional principal)
hadgrownto about$2.4 trillionon a worldwidebasis. This
expansion is truly remarkablewhen one realizes that the
first single-currencyinterestrate swap was not transacted
until 1982. Further,the pervasivenessof these commit-
ments is equally impressive.For example, a recentsurvey
of chief financial officers by InstitutionalInvestor [5]
showedthatnearlythree-quarters of the corporationswith
revenuesof at least $3 billion have used swaps.
The analysis representedin this manuscriptoriginatedwhile the authors
were Senior Consultantsto ManufacturersHanoverTrustCompany.We
would like to thankFranklinAllen, two anonymousreferees and, espe-
cially, LaurieWinstonof ChemicalBankingCorporationfor her insights
into much of the materialwe discuss.
94
the
Swaps
The explosive growthin the swap marketover the past
decade has masked one vital concern about these agree-
ments.Simply put,thoughit is generallyregardedas a tool
for reducinginterestraterisk,an interestrateswap is itself
a risky transaction.Aggrawal [2] summarizedthe various
types of exposure borne by the swap user, includingrisk
due to unexpectedchangesin marketpricesandregulatory,
legal, and accountingmatters.But the most importantof
these risksis the potentialeconomic loss thata firmwould
incurif its counterpartydefaultedon the swap agreement
when interestrateshave moved adversely.Financialman-
agers have now become awareof the defaultcosts associ-
ated with using interest rate swaps, which, accordingto
Cooperand Mello [6], are likely to be subordinateto debt
claims in the event of bankruptcy.As an indicationof this,
the same Institutional Investor survey reported that
roughly80%of the CFOsrespondingexpressedincreasing
concern over the creditworthinessof their swap partners,
with over one-third of that group admitting to having
actually rejected a potentialcounterpartybecause of this
risk.
INTERESTRATESWAPS/ BROWN&SMITH
It is difficultto get accuratedataon defaultlosses in the
swap market because many transactionsapparentlyare
worked out without technical default. Kapner and Mar-
shall [9] reportedresults from a 1987-1988 ISDA survey
indicatingthatonly 11 of 71 swapdealershad experienced
write-offs, amountingto just $33 million on aggregated
portfolios at that time of $283 billion. While this figure
suggests very low default rates, it pre-dates the court-
ordered default on swap positions held by British local
authorities(i.e., municipalities)wherebya numberof bank
counterpartiesstand to lose amounts estimated at ?500
million on positions that reached a maximum notional
principalof over ?10 billion. In thatcase, the courtsruled
that the local authoritieshad exceeded their legal power
becausethe swappositionscould not be justifiedas hedges
and thus were considered outright speculation.Further,
although a 1992 ISDA survey indicated that only about
0.5% of the outstandingnotional principal over the last
decade was lost to default,Glasgall andJavetski[7] noted
that workoutswere also needed to transferpositions in-
volving the failed institutions,Bank of New Englandand
Drexel BurnhamLambert, with the latter's swap book
totalingover $30 billion.
There are two ways of viewing swap default risk: (i)
actual exposure, which is a measure of the loss if the
counterpartywere to defaultandis basedon the movement
in swap marketrates between the inceptionof the agree-
ment and the currentdate; and (ii) potential exposure,
which is based on a forecast of how marketconditions
might changebetweenthe presentandthe swap'smaturity
date, includingin some mannerthe probabilityof default
by the counterparty.Thus far, the academic literaturein-
vestigating this topic has concentratedon estimatingthe
value of potentialexposure and showing how it is shared
between the counterparties.Simons [11] demonstrated
how many of the ad hoc estimation techniques used in
practice could be improvedby employing simulationsof
differentfutureinterestrate environments.This approach
was generalizedby Sundaresan[13] who assumed a sto-
chastic process to characterizefutureinterestrate move-
ments in order to show how default risk impacts swap
valuation.Cooperand Mello [6], in additionto producing
a theoretical model for valuing potential default risk,
examined the transferof this risk between three groups
associatedwith a firm:shareholders,debtholders,and the
swap counterparty.While this focus on potentialexposure
is important,what remains largely unaddressed is the
extentof the actualdefaultrisk thataccumulatesas a swap
position seasons. The goal of the present research is to
95
exploreways in which the structureof the swapagreement
can be revised to reducethis type of exposure.
The analysisis organizedas follows. Inthe firstsection,
we develop an analytic frameworkto measureactualde-
fault exposure and discuss the market practices widely
used to deal with thatrisk. Section II outlinesthe mechan-
ics of the mark-to-marketswap, the first of two design
innovationswe examine. We demonstratethat the mark-
to-market swap agreement is essentially a sequence of
swap commitments,each of which is liquidated after a
single settlementperiod. A second design innovation,the
forwardrate swap, is introducedin Section III. In this
approach,the usual swap structureis modified at the time
of its originationby alteringthe patternof fixed swaprates
to reflect expectations about the marketconditions that
will prevail on the future settlementdates. Examples of
both designs, along with a discussionof practicalissues in
their implementation,are presented in each respective
section. In the final section, we offer some concluding
comments.
I. DefaultRisk on an InterestRate Swap
A.MeasuringDefaultRiskExposure
Default risk exposure on an interestrate swap differs
from that on an ordinarybond in three importantways.
First,the most common (i.e., "plainvanilla")swap struc-
ture requires no exchange of principal payments at in-
ceptionor maturity,establishinginsteada notionalprinci-
pal used to convertinterestrates into cash flows for each
settlementperiod. Therefore,there is no principalat risk.
Second, a swap is an executory contract,signifying that
one partyneed performonly if the counterpartyalso per-
forms. If one partyceases paying the fixed rate,the other
need not pay the floating rate. Combined,these two con-
siderationsindicate why the risk exposure on a swap is
significantlyless than that on a bond of comparableface
value. In fact, the exposure is limited to the difference
betweenthe presentvalues of the remainingfixed-rateand
floating-ratecash flows. Because that net present value
may be positive or negative,the thirdimportantdifference
betweena swap anda bondis thatthe defaultriskexposure
is bilateralin thateach partymustbe concernedaboutthe
possible defaultof the other.
To measuredefaultrisk, supposethaton date -T (i.e., T
periodsago, relativeto the currentdate 0) FirmsA and B
agreedto a swap transactionwhereinFirm A makes pay-
ments based on a prespecifiedfixed rate every settlement
date in exchange for receipt of cash flows based on a
96 MANAGEMENT
FINANCIAL / SUMMER1993

Exhibit 1. Time Frameand Cash Flow Diagramsfor a HypotheticalSwap Transaction

PeriodicSettlementDates
II II I I II
I I 1 2 N- I
-T 0 N

Swap Current Swap

Origination Date Maturity
Date Date

Floating Rate Index (It-1)

4
FirmA Firm B

FixedFixed(FT, N+T)
Rate (F-T,N+T)

variableinterestrateindex. Settlementtypicallyis on a net
basis, the differencebetweenthe fixed andfloating flows.
This transaction,assumed to matureat date N, will then
have a total of T + N settlementdatesover its lifetime. Let
F-T, N+T be the fixed rate in the transaction(denotingthe
rateestablishedat date -T for a swap with T + N periodsto
maturity)and lt- be the index rate observed at date t- 1
and payable at date t. Swaps typically settle in arrearsin
that the floating rate is set at the beginning of the period
and paymentis made at the end. The relevanttime frames
andcash flow exchangesfor this transactionareillustrated
in Exhibit 1.
Now suppose that immediately after the settlement
payment(or receipt) on date 0, Firm B entersbankruptcy
proceedings,therebydefaultingon the remainingN settle-
mentobligations.Assumethaton date0 the currentmarket
fixed rate on a swap with N periodsto maturityis Fo,N, a
rate assumed to be higher than F-T,N+T. As the payer of
what had been a "below-market"fixed rate,FirmA expe-
riences a loss equal to the following amount:
where VOis the economic value of the swap on date 0, r't
is the (zero-coupon) risk-adjusteddiscount rate appro-
priate for each of the remaining N cash flows, and NP is
the notionalprincipalon the swap. The value of the swap
to FirmA on date0 is the discountedvalueof thedifference
between the cash flows generatedby the higherfixed rate
on a replacement swap (Fo N) and its original level
(F-T,N+T) If V0 were negative, implying that F() N is less
than F-T. N+T,Equation(1) would representthe amount
thatFirmA would gain if its counterpartywere to default.
In that case, Firm B would be receiving an above-market
fixed ratefor paymentof the floating-rateindex;the swap
would representa valuableasset ratherthan a liability to
be extinguished in bankruptcy.Clearly, Firm B would
choose not to default on the agreement,ratherit would
preferto continuethe transactionor attemptto transferit
to a thirdpartyat a profit.
FirmA's actualriskexposure(RE)following defaultby
FirmB at date 0 can then be summarizedby:

N -
(Fo. N F-T, N+T)(NP) (FO N - F-T N+T)(NP) if >
Vo = y_ REA 0 = N+T
RA?St (1 + ^)t
t=l (1 + r)t
0 otherwise. (2)
INTERESTRATESWAPS/ BROWN&SMITH
Similarly,as the fixed-ratereceiver,FirmB's riskexposure
at date 0 is:
(F-T, N+T -FO, N)(NP)
0 FO, <
f F,N+, -T,N+T
0RE-B2= (1tt + rt)
0 otherwise. (3)
Equations(2) and(3) arethe mark-to-market riskexpo-
sures for Firms A and B in that they summarizethe loss
that would be incurredbased on the currentswap market
rate.Notice thatthe exposuresdependon the joint occur-
renceof two events:(i) the defaultby the counterparty,and
(ii) an adversemovementin interestrates.While potential
defaultrisk at originationmay be bilateral,becauseof this
second condition the actual exposures at any subsequent
date will be unilateral.Thatis, it will neverbe the case that
both partiessimultaneouslyhave positive mark-to-market
exposuresto one another.1
How defaultrisk exposure evolves over time depends
fundamentallyon the replacementswap fixed rate, Fo,N,
and the time remainingin the contract,N. Generally,the
more that Fo,N diverges from the existing rate, F-T,N+T,
and the largeris N, the greateris the defaultloss. Earlyin
the life of the swap, whenN is high butF, Nis likely to be
relatively close to FT, N+T, the exposure would be rela-
tively small. At an extreme, if the counterpartyenters
bankruptcyproceedings immediately after signing the
swap document,the default loss is likely to be negligible
given thatthe firmpresumablycan replacethe swap at the
same marketrate. Late in the life of the swap when N is
low, the exposureagain can be small despite a significant
spreadbetween F0, N and F-T,N+T.In fact, at maturity,the
risk exposure cannot exceed the difference between the
floating-rateindex at the last settlementdate (IN-1)andthe
fixed rate, times the notionalprincipal.Overall,mark-to-
marketrisk exposure is likely to reach an internalmaxi-
mum at some time between the originationand maturity
dates.
lIn addition to mark-to-marketexposure, which representsthe actual
consequence of a swap default at a specific point in time, many swap
marketparticipantsare also concerned with estimating the maximum
potentialrisk over the agreement'slifetime. These counterparties,typi-
cally money-centerbanksconcernedabouttheir total creditexposureto
a corporateclient, often determinea measurecalled fractionalexposure.
Althoughwe have foundthatproceduresfor calculatingfractionalexpo-
surevaryacrossinstitutions,it is essentiallyan estimateof the worst-case
scenariofor mark-to-market riskbetweenthe presentdateandthe swap's
maturity.Thus, fractionalexposureis analogousto the potentialdefault
risk measureanalyzedby Simons [11] and Cooperand Mello [6].
97
B. MarketPractices to Deal With
DefaultRisk
Most swap market makers are either commercial or
investmentbanks. Because of the fundamentaldifference
in the natureof their business, however, they deal with
defaultrisk on swaps differently.Commercialbanksarein
the credit-risk-bearing business- thatis theirchief func-
tion and source of marketexpertise.2As such, they have
tendedto price defaultrisk explicitly into the fixed rateon
the swap, raising their receive-fixed (offer) rate and low-
ering their pay-fixed (bid) rate as compensation to the
extent that the counterpartyrepresentsadditionalrisk. As
would be expected,the presenceof greaterrisk widens the
market maker's bid/offer spread. Similarly, entering a
swap with a strongercounterpartywould induce the bank
to narrowits bid/offer spread.Investmentbanks, on the
otherhand,arenot in the businessof bearingthe creditrisk
of customersover the long-term.Consequently,they have
tended to use letters of credit and posting of collateralto
raisethe effective creditstandingof weakercounterparties
to their level. Rather than pricing the default risk of a
particularfirm into the fixed rate on the swap, investment
banks would have a uniformbid/offer spreadapplicable
only to acceptablecounterparties.
The key point is that it is the imbalancein degrees of
credit risk between the counterpartiesthat motivatesthe
adjustmentin the fixed rateon the swap or the requestfor
collateral(or letterof credit).Giventhateach counterparty
must assess its default risk exposure to the other,neither
would be very willing to give up somethingin the agree-
ment without getting the same in return.So, collateralis
used in the swap marketmostly to equalize a disparityin
the creditworthinessof the counterparties,not to manage
the inevitableexposurethatariseseven betweentwo com-
parablefirms.3Mutualexchange of collateralpresentsthe
problemof retrievingthe securitiesthathadbeen postedif
the counterpartywere to defaulton the swap, especially if
those securitieshad been lent out in the "repo"market.An
alternativewould be to post collateralwith a thirdparty
2A motivation for commercial banks to enter and promote the swap
markethas been to generateoff-balance-sheetincome andto exploittheir
comparativeadvantagein credit-basedproductsat a time whentraditional
lending to corporatecustomers was falling off. Brown and Smith [3]
describedthis as the "reintermediation" of commercialbanking.
3This follows, in part, from the idea advancedin Brown and Smith [4]
thattherewill be a commonfixed ratefor all swaptransactionsinvolving
counterpartiesof comparablecreditworthiness.That is, in equilibrium,
two AA-ratedfirmswill negotiateto the samefixedrateas two BBB-rated
credits.
98
acting as a clearinghouse.The value of securities to be
posted could be a fractionof the notionalprincipalor the
marketvalue of swap. In any case, the use of collateral
raises transactionscosts in the same manneras the margin
accounton an exchange-tradedfuturescontract.
Because of the bilateralnatureof potentialcredit risk,
swaps are negotiatedon a more "level playing field" than
typically encounteredwith bank loan contracts.That, in
turn, also limits the ability of both parties to demand
restrictivecovenants.However,there are two such items
thatusuallyarecontainedin swapdocumentation.The first
is a cross-defaultclause which triggersthe swap's default
in the event that any indebtednessof one of the counter-
parties is either in default or has been accelerated.This
provisionmitigatesthe effects of what we describebelow
as a default-timingoption. Second, swap agreementsalso
often require that multiple contracts between the same
counterpartiesbe netted against each other,which elimi-
nates the ability of the defaultingparty to "cherry-pick"
contracts- i.e., defaulton only those with negative eco-
nomic value while maintaining the ones with positive
value. To guarantee that provisions such as these are
adopted,marketmakerspreferthatcustomerssign a mas-
ter swap agreement to expedite future transactionsand
ensurethatall existing swap positions can be nettedout if
a defaultwere to occur.
A default-timingoptioncan ariseif the defaultingparty
can benefit by postponingthe event of default itself. Sup-
pose thatthe economic value of the swap, as measuredby
Equation (1), is negative but the firm is scheduled to
receivea paymentat the next settlementdate.Forexample,
assume Firm B is in serious financial distress at a time
when Fo,N > F-TN+T and IO< F-T,N+T. This means
that the existing receive-fixed rate is below-marketeven
though the next scheduledsettlementprovidesa net cash
inflow. This could occur if the yield curve dramatically
steepenedafterthe swap was originated,drivingthe short-
term index rate down and the longer-termfixed rate up.
FirmB clearlywouldhaveno reasonto defaulton the swap
prior to the next receipt. In general, it would have an
incentive to defer defaultingon the swap as long as the
floating-rateindexcalls for net cash inflows. Moreover,all
creditors of Firm B would concur with the decision
to defer default until a time when F, N > F-T, N+T and
Io > FT, N+T.4 As noted, a cross-default clause works
4Therealso is a plausible scenario whereby Firm B would elect not to
defaulteven thoughbothF0 N > F-T N+TandI( > F-T, N+T.Dependingof
the level of Io, the firm could choose to make a small net settlement
payment to keep the swap alive, in hope that swap marketfixed rates
FINANCIAL / SUMMER1993
MANAGEMENT
against such a default-timing option by identifying as
events of defaultfactors other than direct nonpaymentof
an owed amounton a settlementdate; for instance,filing
of bankruptcyproceedingsby any othercreditorwill also
bring the swap into default,triggeringterminationof the
agreement.
II.Swap Design Innovations:
Mark-to-MarketSwaps
A. Revisingthe Structureof the Swap
Agreement
We have shownthatanyfirmengagedin an interestrate
swap will incura loss if its counterpartydefaultsat a time
when interestrates have moved in an adverse direction.
One way to eliminatethis exposureis to have the partici-
pantsliquidatetheirexisting agreementeverytime interest
rateschange andthenrenegotiatethe termsof a new swap
to reflect the prevailing market conditions. Of course,
because interestrates are never static this solution is im-
practicalin that it would requirevirtually perpetualex-
changesof mark-to-market cash flows. As a moremanage-
able alternative,the counterpartiescould agreeto a scheme
in which the renegotiationsoccur only on the periodic
settlement dates of the swap (i.e., when cash flow ex-
changes were scheduledto occur anyway).That is, imag-
ine thatFirmsA and B had structuredthe following agree-
ment at date -T:
(i) Enter into a plain vanilla swap for T + N periods
with Firm A paying, and Firm B receiving, the
fixed rate of F-T,N+T;
(ii) On the first settlementdate (i.e., date -T + 1), the
counterparties: (a) maketheirrespectivefixed- and
floating-ratepaymentson the existing swap; and
(h) liquidatethe remainingportionof the existing
swap accordingto Equation(1) above, using the
current swap rate as the discount factor for all
future cash flows, i.e., set rt equal to F_T+i,N+T-1,
which would be the fixed rate as of date -T + 1 on
swap havingN + T - 1 periodsuntil maturity;
(iii) Immediatelyupon unwindingthe old swap, the
participantsenterinto a new swaphavingthe same
notional principal as the original but (N + T - 1)
subsequentlyfall andthe swaptakeson positiveeconomicvalue. Ineffect,
the periodicsettlementpaymentis the premiumfor an out-of-the-money
optionon an interestrateswap. The value of thatoptionmightexceed its
purchaseprice.
INTERESTRATESWAPS / BROWN& SMITH
periods to maturity.The new fixed rate on this
swap, again, would be F-T+, N+T-1;
(iv) Repeat steps (ii) and (iii) on each settlementdate
untilthe maturityof the originalswap (i.e., dateN).
This procedure,though admittedlycontrived,captures
the essence of the mark-to-marketswap transaction.For-
mally, ratherthanhavingthe counterpartiesenterandthen
unwind (N + T - 1) different swaps - as is implied by the
above scheme -the mark-to-marketswap would be a
single agreementmade at date -T and terminatingat date
N. The differencebetweenit andthe plainvanillacommit-
ment covering the same period is that while the latter
generatesdefaultrisk exposurebetween dates -T and0 by
leaving the fixed rate set at F-T,N+T, the mark-to-market
swap eliminates this exposureon each settlementperiod.
It does this by having the counterpartiessettle in cash any
changein the swap'seconomic value andthenresettingthe
fixed rateon the remainderof the agreementto the prevail-
ing level. Thus,FirmA's settlementpaymentat date 0 can
be written:
N includingboththefixed paymentson theexisting swapand
(F_l N+l -/_1)(NP) - (Fo N- F-, N+O)(NP)
as noted above, the new swap fixed rate is used as
where,
where, as noted above, the new swap fixed rate is used as
the common discount factor for all future cash flows.
Notice that Equation (4) consists of two parts, the first
being the schedulednet settlementpaymenton the existing
swap andthe secondbeing the presentvalue of unwinding
the remainderof that swap accordingto Equation(1).
Beyond its ability to reduce default risk, anotherkey
propertyof this "marking"procedureis that the overall
internalrateof returnon a swap-linkedvariableratefund-
ing structureis relativelyinvariantto the exact swap rate
that prevailson each futuresettlementdate. This follows
directlyfrom the trade-offthatis createdbetween making
(receiving)a swap unwindpaymentandthenadjustingthe
remainderof the agreementto a lower (higher)rate.Con-
sequently,no matterwhat path interestratesfollow in the
future,the swapunwindpayment- andsubsequentreset-
ting of the fixed rateon the "new"swap - always link the
processbackto the conditionsin the marketat date0. This
point is illustratedby the following example and docu-
mentedmore thoroughlyin the Appendix.
B. A NumericalExample
Suppose that a corporationhas just issued a two-year,
floating-ratenote (FRN) with a par value of $10 million,
99
calling for semiannual interest payments based on the
LondonInterbankOfferRate (LIBOR).Because this firm
presumablywould prefera known cost of funds but now
wouldbe exposedto risingrates,it can convertits new debt
into the equivalent of a fixed-rate issue via the swap
market.This can be accomplishedby enteringa pay-fixed,
two-year (i.e., four settlementperiod) swap against six-
month LIBOR with a notional principalof $10 million.
Thatis, as floating-ratepaymentsare requiredon its FRN,
the firm will receive an equal amount from its swap
counterpartyin exchangefor cash flows basedon the fixed
swap rate.Lettingthe currentfixed ratefor such an agree-
ment be Fo,4 = 9.00%, Exhibit 2 summarizesthe data
necessary to illustrate the mechanics of the procedure
outlinedabove.5
Panel A specifies one possible patternfor swap fixed
rates on each future settlementdate. Note that with each
successive settlement date, the maturityof the swap is
reducedby six monthsto matchthe remainingmaturityon
the underlyingnote. Panel B shows the calculationsof the
periodic cash flows associated with these assumptions,
(4) the liquidationvalue of the remainderof that swap.6 For
example, on date 1 the economic value of the existing
agreementis Vo = -$69,049, a negative amountsince the
firm is obligated to pay 9.00% when the currentmarket
rate is only F1 3 = 8.50%.The corporationwould have to
pay its counterpartythat amountto close out the existing
agreement.In addition,the fixed paymentdue on thatdate
is $450,000, given the initial fixed rate of 9.00%. Finally,
PanelC computesthecorporation'ssyntheticfundingcost,
expressed as the internalrate of returnof the combined
FRN/swaptransaction.
This examplehighlightstwo importantattributesof the
mark-to-marketswap. First, and most importantly,notice
that when measuredto the basis point the internalrate of
returnon the aggregateposition is 9.00%. Of course, this
5It should be noted that this example is typical of how corporations
participatein the swap market.In fact, Wall and Pringle [14] provided
surveydata indicatingthatlarge companiesare five times more likely to
be fixed-rate payers than fixed-rate receivers. This same study also
contains an excellent discussion of the many motivations for using
swaps.
6In these calculations,two simplifying adjustmentshave been made to
Equation(4). First,the scheduledsettlementpaymentis listed on a gross
basis, ratherthan net of the LIBOR-basedswap receipt. This was done
because the floating-rateswap receipt will merely be passed throughto
the firm'sbondholdersand can thereforebe ignored.Second, all interest
rateswere alteredto reflectsemiannualpaymentperiodseventhoughthey
were originallyexpressedon an annualbasis.
100 FINANCIAL / SUMMER1993
MANAGEMENT

Exhibit 2. Illustrative Example of a Mark-to-Market flows from period to period. The exact payment pattern
Swap Transaction will dependon the pathof the fixed rateson the sequence
of replacementswaps, which in practicecould come from
Panel A. AssumedFutureSwap Rates
the marketmaker'sown quote sheet or as the medianof a
Settlement Prevailing Necessary set of quotes from competing swap dealers. We should
Date Swap Rate Swap Maturity stress, though, that the plain vanilla swap keeps the peri-
0 9.00% 2.0 years odic cash flows constantat the expense of creatingdefault
1 8.50% 1.5 years riskexposurefor one counterpartyor the other.The whole
2 9.50% 1.0 years
3 10.00% 0.5 years point of the mark-to-marketstructureis to eliminate this
4 8.75% exposure on each settlementdate by convertingit to an
obligatorycash payment.
Panel B. Bond Issue and Periodic Swap SettlementPayments

Date 0: C. Practical Considerations

IssueBond = -$10,000,000 Mark-to-marketswaps have been tradedin some form
Date 1: since 1987. Originallycreatedby ManufacturersHanover
3
- (1 + 0.0425)
Trust Company as a means of giving less creditworthy
SwapUnwind = , [(0.09- 0.085)(0.5)(10,000,000)]
t=l
firms access to the swap market,the producthas gained
= $69,049 slow, but steady, acceptance. Two difficulties often are
SwapSettlement = (0.09)(0.5)(10,000,000)= $450,000 cited by practitionersas barriersto implementing this
Date 2: innovation.First, many counterpartieslack either the ex-
2
SwapUnwind = E [(0.085- 0.095)(0.5)(10,000,000)]
- (1 + 0.0475) pertise or the back office technical supportnecessary to
t= trackthe cash flow changes duringthe life of the agree-
= -$93,301 ment. In such cases, the only alternativeis to rely exclu-
SwapSettlement = (0.085)(0.5)(10,000,000) = $425,000
sively on the calculationsof the swap dealer, something
Date 3:
= [(0.095 - 0.10)(0.5)(10,000,000)] - (1 + 0.05) many firms are understandablyreluctantto do. This is a
SwapUnwind
= -$23,810 particularconcernfor a sizable portionof the professional
SwapSettlement = (0.095)(0.5)( 10,000,000) = $475,000 (i.e., bank)counterpartymarketthathas found it difficult
Date 4: to adapt existing accounting and computing systems to
SwapUnwind =$0 handlea largevolume of anythingotherthanplainvanilla
SwapSettlement = (0.10)(0.5)(10,000,000) = $500,000
RedeemBond =$10,000,000 transactions.
A second reason for the reluctanceof many corporate
counterpartiesto use the mark-to-marketscheme stems
Panel C. TransactionCash Flows and InternalRate of Return
from the unpredictabilityof the cash flow streamsit cre-
ates. Moreprecisely,this swapstructuremightobligatethe
0000,000= 519,049 + 331,699 + 451,190 10,500,000 counterpartyto make sizable unwind payments prior to
(1 +IRR)1 (1 +IRR) (1 +IRR)3 (1 +IRR)4
maturity.For instance,at date 1 in the above example,the
so thatIRR= 4.50% per semiannualperiod,or 9.00% per annum. firm had to pay almost $70,000 more than it expected
based on informationavailableat date 0. A companythat
actuallyhas to raise this money in the capitalmarketmay
find little consolation in the fact that its settlementpay-
is the same net fundingrate thatthe firm would have had
ments will then be loweredfor the remainderof the swap.
if it could have found a counterpartywilling to accept This is a particularconcernto industrialcorporationswho
9.00%as a fixedrateon a plainvanillaswapwithotherwise
may not access their capital sources with the same fre-
comparableterms. Thus, when viewed solely in terms of quencyas do financialfirms.Further,if the firmdoes have
the cost of fundsoverthe entiretwo years,the plainvanilla to tap externalfunding sources, its internalrate of return
and mark-to-marketswap structuresachieve the same will only equal the originalfixed rateon the plain vanilla
result.Second, unlikethe plainvanillaswap, which would agreementif its borrowingcost is equal to the prevailing
have requiredconstantsettlementpaymentsof $450,000, fixed swap rateused as a discountfactor.However,if the
the mark-to-market scheme generateshighly variablecash firm's cost of capitalexceeds Fo N, its aggregatefunding
INTERESTRATESWAPS/ BROWN& SMITH
cost from the bond/swap combination will exceed
F-T, N+T
On the otherhand,participantsin the swapmarkethave
found two featuresof the mark-to-marketstructureto be
quite attractive.The most appealingattribute,of course, is
the ability to mitigate the actual default risk exposure to
their swap counterparties.In principle, it is possible to
reduce this exposure even furtherby markingthe agree-
ment more frequently,perhapsusing a system of margin
accounts to collateralize the adjustmentprocess. Practi-
cally, though, this variationcreates measurablecosts for
the firm in that additionalresources would have to be
committedto monitoringits position. Further,it is likely
to violate the guidelines created by the Commodity Fu-
turesTradingCommissionto keep the swap andexchange-
tradedfuturesmarketsdistinct.The second desirablefea-
ture of the mark-to-marketformatis thatneithercounter-
partyis hurtby a miscalculationof the new fixed swaprate
on each settlementdate. Thatis, if the reset rateagreedto
on date t is (F, N-t + ?), as opposed to its "true"level of
Ft, N-t, the fixed-ratepayerwould thenbe requiredto make
higher futuresettlementpaymentsbut receive the present
value of thisamountas an unwindpaymentat datet. Again,
this stressesthatthepatternof futureresetrates- whether
drivenby marketforces or humanerror- is not by itself
an importantfactor.
III.Swap Design Innovations: Forward
Rate Swaps
A. Departuresfromthe PlainVanilla
Swap Structure
The inherent structureof a plain vanilla interest rate
swap, wherebya single fixed rateappliesto all settlement
dates, is itself a source of defaultrisk. This is because in
virtuallyall yield curve environments,therewill be actual
defaultriskexposureassociatedwith a given contracteven
if interest rate movements are nonstochastic. In other
words, if the futurepath for the floating-rateindex were
fully deterministic,a firmwould typicallyincura financial
loss if its swap counterpartydefaulted. The exceptional
circumstancewhen this might not occur is an extended
period of constant interest rates and a totally flat yield
7A similarstatementcan be made for the unwindfundsreceivedon each
settlementdate. If these receipts cannot be reinvestedat Fo N, then the
actualinternalrateof returnfor the combinedtransactionwill notbe equal
to F-T.N+T
101
curve.Thatrarityaside, defaultrisk arisesbecauseinterest
ratesare stochastic,a realityexacerbatedby the setting of
a uniformfixed ratefor the lifetime of the swap.
Consideragainthe fixed rate(Fo,N)on a new N-period
swap set on date0. Forbothcounterpartiesto the swap,the
sequence of expected future payments and receipts is
determined by the sign of Fo, N - E(It 1). However, assum-
ing risk-neutralparticipants,the swap marketwill be in
equilibriumonly if the presentvalue of the fixed flows set
by Fo, N equal the presentvalue of the expected variable
flows set accordingto It. This, in turn,meansthatthe swap
has an initialeconomic value of zero to each counterparty
if the following conditionholds:
((FO, - E(It))
(F0,N - I)
(5)
(I +F l)I t =2 (l +'t)t
Note fromEquation(5) thatthe initialexchangeat the end
of the first period is based on the known, currentlevel of
the floating-rateindex(Io)while subsequentexchangesare
only known to the level of theirexpected values.
Suppose that the overall marketenvironmentis one of
expected rising short-termrates,reflected by an upward-
sloping yield curve. This means that as the single swap
fixed rate, Fo,N, will be a complex average of the yields
expected to prevailduringthe N-periodlife of the agree-
ment. Consequently,for the fixed-payer (fixed-receiver)
on the swap, thereis likely to be some futuredate t* after
(before)whichthe firmexpects to be receivingcash settle-
ment paymentsand before (after) which it expects to be
making payments. To the fixed-payer, the default risk
exposure is then "back-loaded"in that it would be more
concerned about its counterpartydefaulting in the later
years of the agreementwhen receiptsare anticipated.For
the fixed-receiver,on the otherhand,thedefaultriskwould
be front-loadedbecause it expects to be receiving settle-
ment paymentsearly andto be payinglater.These conclu-
sions, of course,implicitlyrely on the expectationstheory
of the yield curve and the parties to the swap having
subjectiveexpectationsaligned with the overallmarket.
A departurefrom the structureof a plain vanilla swap
to address this front-loadingand back-loadingproblem
would be to set a time-varyingfixed rateon the swap.That
is, the fixed rate would be prespecified for all future
settlementperiodsat inceptionbut it would differfor each
period so as to minimize expected settlement payments
andreceipts,therebyminimizingthe expecteddefaultrisk.
For example, suppose that the uniform fixed rate is re-
placed in Equation(5) with the set of impliedforwardrates
102
known at date 0, based on the swap yield curve for matu-
rities rangingfrom one to N periods.
(IFRo1- Io) (IFRtt- E(It-)) 0 (6)
+(IFRo,
Io)() 0 the three-yearswap as the fixed-ratepayer at the market
(l +1) +t=2 (1+
where IFRo,1 is the observed rate (e.g., LIBOR) for a
transactionbetween dates 0 and 1 and IFRt_,t is the
implied forward rate on a one-period security between
datest - 1 and t. An agreementstructuredin this fashion is
what we call aforward rate swap. It is not a forwardswap
in the sense of a having a deferredstartingdate, ratherit
contains a sequence of forwardfixed rates for futureex-
changes.This sequenceneed not be limitedto just implied
forwardrates calculated from spot marketquotations;it
could come from observedratesin the explicit forwardor
futuresmarket.For example,Eurodollarfuturesand over-
the-counterforwardrate agreement(FRA) marketscould
be used to establishthe sequence.8In fact, the set of rates
could simply be mutuallyacceptableto the two counter-
partiesbasedon theirown subjectiveprobabilitiesof future
rates.
The reductionin default risk exposure depends criti-
cally on the extent to which the actualpath for the float-
ing-rateindex follows the trajectoryof the forwardrates.
If the differencebetween the two is small, defaultrisk can
be substantiallyreduced. For instance, if IFRt I, is a
reasonablygood measureof E(lt_), the expected payoff
for each futuresettlementdate shouldbe less than setting
a single fixed rate.Note thatthe impliedforwardrateneed
not be a perfectpredictorof futuremarketratesfor default
risk exposure to be reduced as long as the variance of
(IFRt_ ,t - It- ) is less than the variance of (FO,N - It-l)
However, it should be emphasized that if interest rates
move significantly away from the implied forwardpath,
the defaultrisk can be even higher thanon a plain vanilla
swap structure.So, unlike the mark-to-marketswap, a
forwardswap might not always reducedefaultrisk.
B. A Numerical Example
Suppose that the fixed rates on one-, two-, and three-
year annualsettlementinterestrateswaps (againsttwelve-
month LIBOR) are Fo, 1 = 8%, F, 2 = 10%,and Fo, 3 =
8Thisis consistentwith the observation,expressedin Smith, Smithson,
and Wakeman[12] and Kawaller [10] among other places, that plain
vanilla interestrate swaps can be replicatedto some degree by stripsof
either over-the-counterforwardor exchange-tradedfuturescontractson
the index interestrate.
FINANCIAL / SUMMER1993
MANAGEMENT
11%,respectively.Currenttwelve-monthLIBOR is also
eight percent, so the one-year swap quote really only
providesa benchmark- it wouldbe an agreementto both
pay andreceivethe sameknownrate.Thus,if a firmenters
rate of 11%, it knows in advancethat it is scheduled to
make a settlementpaymentin one yearequal to (F0 3 - 10)
= 3%times the notionalprincipal.Similarly,the fixed-rate
receiver is assured of the receipt of the same amount,
barringdefault by the counterparty.Clearly, the market
levels for LIBORin one and two years (i.e., I1 andI2) will
determine which counterparty ultimately receives the
greatercash inflows. The fixed-ratepayer gains if future
LIBOR rises sufficiently above 11%in futureperiods to
compensatefor the first year's known cash outflow.
The implied forwardrates based on this swap yield
curve are IFRo, = 8% (= Io) for the first year, IFRI 2 =
12.245% for the second, and IFR2 3 = 13.408%for the
third.9The forwardrate swap structurewould set the fixed
rate for the first-yearsettlementat 8%, the second-year
settlementat 12.245%,andthethird-yearat 13.408%.That
this swap has the same initial economic value as the plain
vanilla structureusing a single fixed rate of 11% for each
period can be demonstratedby calculating the present
values of each fixed cash flow stream:
-8%++ 12.245% + 13.408%C 27.261c
1.08 (1.10102)2 (1.11193)3
11% 11% 11%
= + + (7)
1.08 (1.10102)2 (1.11193)'
While theplainvanillaandforwardratestructureshave
the same initialeconomic value,the degreesof defaultrisk
9To calculate the implied forwardrates, one first needs to derive (or
observe in the market)the zero-couponratesthat areconsistentwith the
prevailingyield curve on coupon securities. In this context, the phrase
"consistentwith"meansthattherewould be no arbitrageprofitsavailable
from buying the coupon bond and selling its coupon and principalcash
flows as separatezero-couponinstruments,nor from buying zeros and
"reconstituting"the coupon bond. Iben [8] has provideda discussion of
this techniqueand its applicationin the swap market.For example, the
two-yearzero-couponrateof 10.102%is found as the solutionfor Z, in:
100 = 10/1.08 + 110/(1 + Z,)2. The par value purchaseprice of the
two-year bond must equal the present value of the future cash flows.
Similarly,the three-yearrateof 11.193%is found as the solution for Z3
in: 100 = 11/1.08 + 11/(1.10102)2 + 111/(1 + Z3)3. Notice that the
first-year'scoupon flow of 11 is discountedby the known eight percent
one-yearrate and the second year's flow is discountedby 10.102%,the
result of the previous calculation.The implied forwardrates are then
calculated in the usual manneras: IFR.2 = [(1.10102)/(1.08)1 - I =
0.12245 andIFR2 3 = [(1.11 193)3/(1.10102)21- = 0.13408.
INTERESTRATESWAPS / BROWN&SMITH
exposure and the settlement cash flows will differ by a
considerableamount.Supposethata firmagreesto pay the
fixed rate on a swap and that LIBOR does follow the
impliedforwardratetrajectory(i.e., twelve-monthLIBOR
rises from Io = 8% to IFR1,2 = 12.245% on the next
settlementdate).Witha plainvanillaswap,the firmwould
be obligatedon thatdate to make a settlementpaymentof
threepercenttimes the notionalprincipalbecause LIBOR
at inceptionwas eight percent.In additionto thatpayment,
the swap would have positive mark-to-marketvalue given
that the two-year replacementswap fixed rate would be
above 11%.With 12-monthLIBORequal to 12.245%on
that date and an expected rate for the following year of
13.408%,the replacementswap fixed rate (F1,2) can be
calculatedas follows:
12.245% 13.408% F1, 2 + F1,2
+ = (8)
1.12245 (1.13408)2 1.12245 (1.13408)2
Solving for F1, 2 obtains 12.726%.The economic value of
the swap,andhence the defaultriskexposure,is thepresent
value of the differencebetween 12.726%and 11%for the
next two settlement dates, an amount equal to 2.875%
(times the notionalprincipal).Thatamount,by the way, is
what would be received by the firm in a mark-to-market
swap in exchange for resettingthe fixed rate to 12.726%
for the remaining settlement dates. In sharp contrast, a
forwardrate swap in the same environmentwould entail
no settlementpaymentor receipt on that date. Moreover,
the defaultriskexposurewould be zero. It follows thatthis
structureminimizesdefaultriskto the extentthatthe actual
trajectoryfor the floating-rateindex follows the path set
for the time-varyingfixed rate on the swap. Whatmatters
is thatactualratemovementsarepositivelycorrelatedwith
the scheduledchanges in the fixed rate on the swap.
C. PracticalConsiderations
While thereis an emergingmarketfor mark-to-market
swaps, we know of no actual swap transactionsthat em-
ploy the forward rate structureto mitigate default risk
exposure. One possible reason for this could be similar
back office technical difficulties as with mark-to-market
swaps. A time-varying fixed rate would require some
monitoringand investmentin accountingand information
systems, which, while demandingan increasedtime com-
mitment from the company's treasuryunit, would likely
only burdenthe first-timeuser.The moreplausiblereason,
however, is that swaps between commercial banks and
their corporatecustomers have tended to have the bank
103
receiving, and the corporationpaying, the fixed rate. In
addition,yield curveshave been upward-slopingin recent
years, especially in the intermediate-termmaturitiesthat
typify swap agreements.These two circumstancescom-
bined have moderatedconcern over defaultrisk from the
perspective of the bank, but not necessarily so for the
corporateend-user.On plain vanilla swap contracts,the
corporationsthat are paying the fixed rates would be
making net settlementpaymentsin the early years of the
transactionand receiving them in the later years. This is
preferablefor the bank,since it is mucheasierto assess the
probabilityof financialdistressin the neartermthanin the
more distantfuture.
When the yield curve is upward-sloping,the proposed
forwardrate structurecould even exacerbatethe default
risk exposure from the perspective of the commercial
banks. In the later years of the swap, when the fixed rate
would be higherthanif a single rateappliedto all periods,
a default by a counterpartyscheduled to be paying the
fixed ratewould be more costly to the bank.This suggests
the threerelatedconditionsfor the introductionof forward
rateswaps:(i) corporationsbecomingmoreleery of banks
as counterpartiesand seeking out swap designs thatmini-
mize default risk from their own perspective;(ii) an ex-
tended period of invertedyield curves, such as prevailed
in the early 1980s in the United States and more recently
in the United Kingdom;and (iii) more corporatedemand
to receive the fixed rateon interestrate swaps.
IV.Concluding Comments
The two design innovationswe discuss, mark-to-mar-
ket swaps and forwardrate swaps, both drawthe structure
of the agreement closer to that of an exchange-traded
futurescontract.Futuresexchanges manage their default
risk by daily mark-to-marketvaluation and settlement
transactionsposted to a marginaccount.That this is done
on a daily basis owes to the key role playedby "locals"-
individualtraderswho providemuchof the liquidityto the
marketbut arethinly capitalizedcomparedto institutional
participants,commercialandinvestmentbanks,andmajor
corporations.The fact that plain vanilla swaps do not
typically require margin accounts with daily settlement
(or,moregenerally,anyformof collateralization)has been
centralin their appealto corporatemanagersof financial
risk.So these innovations,which wouldintroduceperiodic
mark-to-marketsettlement and time-varyingfixed rates,
borrowfrom the futuresmarket,yet still maintaina sepa-
rate identity.
104
Default risk arises because firms do fall into financial
distressandmarketinterestratesare stochastic.The mark-
to-marketdesign for the swap uses actualratesto makeex
post adjustmentsto the fixed rate.The forwardratedesign
uses expected rates to make ex ante adjustments.Each
design can effectively transforma floating-rateliabilityto
a fixed-rateliabilitywith a known,locked-incost of funds
subject, of course, to some assumptionsabout reinvest-
ment rates. However,the amountof the net interestpay-
ment for each period is not known in advance with the
mark-to-marketdesign. With the forwardrate swap, the
future amount is known but is likely to differ for each
period. The appeal of the plain vanilla structureis that it
can providea constant,knownnet interestpaymentfor all
periods. The trade-offis one of certaintywith respect to
futurecash flows versus defaultrisk. The mark-to-market
swapmanagesdefaultriskmost effectively,limitingexpo-
sure to rate changes only over the most recent settlement
period. The forwardrate swap manages the risk less pre-
cisely and only to the extent that futurerates follow the
pathstructurein the agreement.Marketratechangesaccu-
mulate on both the plain vanilla and forwardrate struc-
tures,and can lead to a much largeramountof defaultrisk
exposure,given the directionand extent of the ratemove-
ments and the time remaininguntil maturity.Ultimately,
applicationof these innovativedesigns for swap contracts
will dependon economic conditions- as risksarise,tech-
niques and product designs always emerge to manage
those risks.
References
1. P. Abken, "BeyondPlain Vanilla:A Taxonomyof Swaps,"Federal
ReserveBankof AtlantaEconomicReview(March/April1991), pp.
12-29.
2. R. Aggrawal, "Assessing Default Risk in InterestRate Swaps,"in
InterestRate Swaps, C. Beidleman (ed.), Homewood,IL, Business
One-Irwin,1990, pp. 430-448.
3. K. Brown and D. Smith, "RecentInnovationsin InterestRate Risk
Managementand the Reintermediationof CommercialBanking,"
Financial Management(Winter1988), pp. 45-58.
4. K. Brown and D. Smith, "PlainVanillaSwaps: MarketStructures,
Applications,and CreditRisk," in InterestRate Swaps, C. Beidle-
man (ed.), Homewood,IL, Business One-Irwin,1990, pp. 61-95.
5. "CFO Forum: Concerns About Counterparties,"InstitutionalIn-
vestor (March1991), p. 144.
6. I. Cooper and A. Mello, "The Default Risk of Swaps,"Journal of
Finance (June 1991), pp. 597-620.
7. W. Glasgall and B. Javetski,"SwapFever:Big Money, Big Risks,"
BusinessWeek(June 1, 1992), pp. 102-106.
8. B. Iben, "InterestRate Swap Valuation,"in InterestRate Swaps, C.
Beidleman (ed.), Homewood, IL, Business One-Irwin, 1990, pp.
266-279.
FINANCIAL / SUMMER1993
MANAGEMENT
9. K. Kapnerand J. Marshall,The Swaps Handbook,New York,New
YorkInstituteof Finance, 1991.
10. I. Kawaller,"InterestRate Swaps VersusEurodollarStrips,"Finan-
cial AnalystsJournal (September/October1989), pp. 55-61.
11. K. Simons, "MeasuringCreditRisk in InterestRate Swaps,"New
EnglandEconomicReview(November/December1989), pp. 29-38.
12. C. Smith, C. Smithson,and L. Wakeman,"TheMarketfor Interest
Rate Swaps,"Financial Management(Winter1988), pp. 34-44.
13. S. Sundaresan,"Valuationof Swaps," WorkingPaper, Columbia
University,September1989.
14. L. Wall and J. Pringle, "AlternativeExplanationsof InterestRate
Swaps:A Theoreticaland EmpiricalAnalysis,"FinancialManage-
ment(Summer 1989), pp. 59-73.
AppendixA. The InternalRateof
Returnon a Mark-to-Market
Swap-LinkedDebt Structure
In Section II, we noted that because of the trade-off that
is created between making (receiving) a swap unwind
payment and then adjusting the remainder of the agree-
ment to a lower (higher) fixed swap rate, the internal rate
of return is virtually invariant to the exact swap rate that
prevails on each future settlement date. Unfortunately, the
multiperiod nature of the cash flow discounting involved
in the mark-to-market process renders a generalized
closed-form proof of this statement impossible. The es-
sence of these relationships, however, can be captured
analytically. We first present a two-period simplification
of the example summarized in Exhibit 2.
Specifically, suppose a company borrows NP dollars
for two periods at an interest rate It-l that is reset at dates
Oand 1 and paid in arrears. If this company first considers
entering into a "plain vanilla" swap as the payer of the
fixed rate F in exchange for It_1,then its net periodic swap
cash flows on dates 1 and 2 are (F -Io)(NP) and (F-
I1)(NP), respectively. Consequently, the internal rate of
return (i.e., funding cost) on this borrowing can be estab-
lished by solving:
[Io+ (F - Io)](NP) [I1+ (F - I1)](NP)+ (NP)
NP = + 2
(1+IRRp)I (1+IRRp)2
F(NP) (1 + F)(NP)
(Al)
(1 +IRRp)1 (1 +IRRp)2
for IRRp. In this case, IRRp = F as the swapped borrowing
is equivalent to a synthetic fixed-coupon bond issued at par
value.
Alternatively, if this company enters into a mark-to-
market swap agreement, on date 1 the original contract will
be unwound and replaced with a new one at the rate
prevailing for the last period. Letting (F + X) represent this
INTERESTRATESWAPS/ BROWN& SMITH 105

new swap fixed rate, which is also assumed to be the algebraicanalysisfurtheris not fruitful.Forexample,from
discount rate for the unwind payment, the total swap- Equation (4) we have seen that the date T settlement
related cash flows are now given by [(F - II)(NP) - {(F + paymentwith the mark-to-marketcontractis equal to:
X) - F}(NP)(1 + F + X)-1] and [(F + X - I2)(NP)], respec-
tively.Notice thatthe firstof these cash flows (i.e., for date
- N-T - FT-1, N-T+I)(NP)
1) includes both a regular settlement payment on the (FT-I, N-T+1I T-I1P) ) l(F,
V(FTN+ t
original swap and an unwind payment,while the second t=T+1 (1 + Ft, N-T)

(i.e., for date2) is just to settlethe replacementswap.With

these amounts,the cost of fundsusing the mark-to-market which, when calculatedfor 0 < T < N and placed into an
structure(i.e., IRRm)can be found by solving:
equationsuch as Equation(A2), creates a complex poly-
nomial relationship.Whatwe can indicate,though,is how
+F+X) I](NP)++ ( +F+X)(NP) the internalrate of returncalculated for the four-period
NP [F-(X)(1 (A2)
(1 + RRt)1 (1+ IRRm)2
example in Exhibit2 would change undervariousalterna-
tive - and quite extreme - interest rate environments.
Letting O = (1 + F + X) and recognizing that NP can be The chartbelow showsthe valueof IRRmthatwouldobtain
droppedfrom both sides of the equation,Equation(A2) underseveraldifferentcombinationsof: (i) an initial swap
can be rearrangedas: rate, and (ii) subsequentmovementsin replacementswap
rates:
(1 + IRR7)2- [F - (X)(o)- - (0) = 0
]( + IRRm,)

InitialSwap Rate
which, of course, is a straightforwardpolynomial in (1 +
IRRm).As such, it can be solved for IRRmas follows: Replacement
Swap Rates 6% 7% 8% 9% 10%

+X-1)2
(F- 2-X-O1) ?(F- +40 Up 0.25% per period 6.001% 7.001% 8.001% 9.001% 10.001%
IRRm, (A3) Down 0.25% per
2
period 6.001 7.001 8.001 9.001 10.001
Notice thatIRRm? F; thatis, the internalrateof returnon Up 0.50% per period 6.004 7.004 8.004 9.004 10.004
the mark-to-marketstructureis not strictlyidenticalto the Down 0.50% per
period 6.004 7.004 8.004 9.004 10.004
initial swap rate. From Equation(A3), however,it can be
establishedthatthe differencebetweenIRRmandF is quite Up 1.00%per period 6.017 7.017 8.017 9.017 10.017
small. For instance,using the positive root, if F = 8% and Down 1.00%per
period 6.018 7.018 8.018 9.017 10.017
X = 0.5%,IRR = 8.001%;for F = 6% andX = %,IRR
= 6.005%. (Incidentally,the source for this small differ-
ence restswith the reinvestmentassumptionsbuilt into the Finally, notice that this display calculatesIRRmunder
internalrateof returnmeasureandis why in practiceswap the assumptionthatreplacementswap rates always move
unwind payments are usually discountedusing the zero- in one direction.In the present context, this representsa
coupon ratesdiscussed in footnote 9.) "worstcase" scenario;replacementswap ratesthat vacil-
Given that the two-period solution in Equation (A3) latedaroundthe initiallevel would tendto keep IRRmeven
cannot be solved definitively for IRRm,generalizingthis closer to the initial level of F.