Interest Rate Swap Valuation since the Financial Crisis: Theory and Practice

22 Pages Posted: 7 Feb 2017 Last revised: 15 Jun 2017

See all articles by Ira G. Kawaller

Ira G. Kawaller

Kawaller & Company, LLC

Donald J. Smith

Boston University - Department of Finance & Economics

Date Written: June 2017

Abstract

The financial crisis of 2007-09 revealed the importance of counterparty credit risk in the valuation of non-collateralized interest rate swaps. In theory, these valuations rest on assumed default probabilities and recovery rates. These assumptions, however, should be reflected in the risk-adjusted discount rates of the counterparties. Thus, in practice, swap valuations can be generated by discounting prospective swap settlements using risk-adjusted discount rates, cash flow by cash flow. This article demonstrates this method, discerning risk-adjusted discount rates from data that are readily available on the Bloomberg information system. Critically, if the inputs for the two methodologies are mutually consistent, theory and practice should yield identical valuations.

Keywords: Interest Rate Swap Valuation

JEL Classification: G12, G29

Suggested Citation

Kawaller, Ira G. and Smith, Donald J., Interest Rate Swap Valuation since the Financial Crisis: Theory and Practice (June 2017). Available at SSRN: https://ssrn.com/abstract=2912346 or http://dx.doi.org/10.2139/ssrn.2912346

Ira G. Kawaller

Kawaller & Company, LLC ( email )

162 State Street
Brooklyn, NY 11201
United States
718-694-6270 (Phone)
718-852-0214 (Fax)

HOME PAGE: http://www.kawaller.com

Donald J. Smith (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-2037 (Phone)
617-353-6667 (Fax)

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