Potential Credit Exposure on Interest Rate Swaps

Bank of England Working Paper No. 25

Posted: 3 Jun 2000

See all articles by Ian Bond

Ian Bond

Bank of England

Gareth Murphy

Bank of England

Gary Robinson

Bank of England

Date Written: 1994

Abstract

An analytical analogue to the Monte Carlo techniques previously used by banking supervisors to assess the potential credit exposure of interest rate swaps is developed, which permits a more thorough examination of swap exposure. This is done by using the Cox, Ingersoll and Ross (1985) one-factor model of the yield curve to generate interest rate paths from which swap credit exposure paths can be determined.

Even with such a relatively simple interest rate process, the patterns of credit exposure are found to be more complex than the supervisors previous techniques allow: they vary with the level of interest rates, the slope of the yield curve and the volatility of the short rate - all factors which are ignored in the supervisors risk measurement methodology - and have a significantly non-linear relationship with swap maturity. In conclusion, market traders and regulators need to be alert to these factors in determining the appropriate level of capital to hold as protection against counterparty default.

Suggested Citation

Bond, Ian and Murphy, Gareth and Robinson, Gary, Potential Credit Exposure on Interest Rate Swaps (1994). Bank of England Working Paper No. 25, Available at SSRN: https://ssrn.com/abstract=115073

Ian Bond (Contact Author)

Bank of England

Threadneedle Street
London, EC2R 8AH
United Kingdom

Gareth Murphy

Bank of England

Threadneedle Street
London, EC2R 8AH
United Kingdom

Gary Robinson

Bank of England

Threadneedle Street
London, EC2R 8AH
United Kingdom

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