The Impact of Liquidity Risk on the Prices of Swaps with Default Risk

Abstract

In swaps market, one of the most important concerns is the counterparty default risk. If default occurs, the default party may have the right to sell the swap to a third party. However, it is possible that the default party is not able to sell the swap, given the high degree of individualization of swap agreements in the OTC market, and thus, there is an exposure of liquidity risk. This paper, first time in the literature, addresses the importance of incorporating liquidity risk into the valuation of swaps subject to default risk. A model for pricing swaps by incorporating default risk and liquidity risk is presented. Then, using the model, we examine the impact of liquidity risk on the values of swaps subject to counterparty default risk. It shows that the impacts are typically negative. This implies that the effects of liquidity risk may offset the effects of default risk to a certain extent. In some circumstances, such as when the yield curve is of upward shape, the effects of liquidity risk even dominate the effects of default risk. As a result, in the presence of liquidity risk, the swap rate with default risk may be lower than the default-free swap rate. This finding is contrary to the common notion in derivatives markets that a company with low credit quality should pay more for entering a derivative position.

Keywords: derivatives, swaps, default risk, liquidity risk

JEL Classification: G1, C0