The exact nature of market risk will depend upon the nature of the swap: it will be interest rate risk, currency risk, equity market risk or commodity risk, according to the type of swap being considered. Generally intermediaries or counterparties will be able to hedge market risk, but credit risk cannot be hedged. However, it may be reduced substantially by holding a diversified portfolio of credit risks.

Credit risk

The fact that, at least for interest rate swaps, the principals are not exchanged means that the exposure to default is limited to the difference between the present value of the fixed and the floating cash flows. Consider a pay fixed/receive floating swap, first, from the viewpoint of the pay fixed side. We noted earlier that if interest rates have fallen since the swap was initiated, the swap will have a negative value to the pay fixed side — i.e. the present value of the future fixed payments to be made is greater than the present value of the floating payments to be received.

As only the net difference between the fixed and floating payments is transferred, if the pay floating side defaults, the pay fixed side is required only to make net payment that would have been due without default. Therefore the pay fixed side cannot be made worse off by the default of the pay floating side, and therefore is not exposed to credit risk.

In reality, the pay fixed side will feel exposed for not receiving the floating payments, and will therefore wish to establish a new swap. The defaulted swap will be abandoned, maybe paying over its value, and a new swap established paying fixed and receiving floating, presumably at the now lower rates.

If interest rates have risen by the time default takes place, the present value of the fixed flows will fall and the position of the pay fixed side will have positive value because the floating rate cash flows due under the swap will have a higher present value than the fixed cash flows that have been contracted to pay; thus the pay fixed side will be exposed to credit risk. If the pay floating side defaults, the pay fixed will wish to enter into a new swap, but at higher rates of interest than originally negotiated.

The exposure of the pay floating side is the mirror image of that of the pay fixed side. When interest rates rise, the swap has a positive value for the pay floating side, and when rates fall, that value is negative.

The exposure to credit risk is complicated by the existence of payment mismatches: for example, in the case of swaps where the floating pays quarterly but the fixed pays half-yearly. If interest rates rise so that the pay floating side has a positive value, this value will be enhanced by any quarterly interest payment made but not offset by a fixed payment. Thus the exposure to default will be greater in the second half of the six-month period than in the first half.

We have already noted (but it is worth repeating) that the magnitude of the credit risk depends upon whether the swap is a hedging transaction associated with a debt issue or some other contracted set of cash flows, or whether it is a speculative transaction. Clearly the hedging transaction reduces the overall probability of financial distress for the party issuing the swap.

However, over time it will be appropriate to determine whether or not the hedging is at an appropriate level of rates. Hedging strategies currently in place but established in earlier times, when rates were substantially higher, may be imposing costs upon the firm that cannot be absorbed at current price levels.

With currency swaps, the magnitude of the exposure to credit risk is greater because the principals are exchanged along with the periodic cash flows. Otherwise the concerns and analysis are similar to those for interest rate swaps.

Currency risk

This is relevant only for currency swaps. When one party defaults, the other party is exposed to any change in the exchange rates from the date when the swap was initiated to the date when a new hedge is established. From the point of view of a counterparty, the original currency hedge has been disrupted and will have to be replaced. One reason for the development of the currency swap market to hedge long-term currency exposure is the lack of liquidity in the long-term forward or futures market. Thus the new hedge is likely to be another currency swap.

Interest rate risk

If one party defaults under a swap, the non-defaulting party will be exposed to interest rate risk. For example, if the pay floating side defaults, the pay fixed, who will have a floating rate liability that was serviced with funds from the pay floating side, will suffer if interest rates rise. The floating rate liability will become more expensive but can, presumably, only be serviced from the interest rate insensitive cash flows that would have been used to meet the fixed payment. It is therefore essential to replace a defaulting swap as soon as possible after default.

The parties to a swap will also suffer interest rate risk to the extent that their payments and receipts under the swap are not hedged by off-setting cash flows. Considering the pay fixed side first, if its revenues are interest rate sensitive and rates fall, the fixed payments under the swap may become onerous. Thus the party paying fixed should have stable, interest rate insensitive revenues with which to service the swap.

The pay floating side of the swap will also exhibit interest rate risk if the floating payments are not off-set with floating cash flows. For example, if its revenues are fixed and interest rates rise, it may not be able to service the higher floating rate payments.

The counterparties are also subject to some residual interest rate risk if the pattern of the underlying cash flows changes.

From the point of view of the pay floating side, there is a commitment to pay for the life of the swap, whereas under a floating rate loan, that loan could be pre-paid. The loan could also be pre-paid if interest rates increased. This is not possible under a swap. Thus the pay floating side runs the risk of being locked in as rates rise. In addition, if its credit rating improves, the credit spread in the loan market would fall and refinancing of floating rate loans would be beneficial. However, under a swap the credit spread is fixed for the term of the swap. All is not lost, however, because the pay floating side can enter into an off-setting swap on identical terms to the original one and then enter into a new swap on the more advantageous terms.

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