The default risks of swaps

Cooper, I A and Mello, A S (2019) The default risks of swaps. In: World Scientific Reference on Contingent Claims Analysis in Corporate Finance. World Scientific Handbook in Financial Economics Series, 3 . World Scientific, Singapore, pp. 327-354. ISBN 9789814730723

Abstract

We characterize the exchange of financial claims from risky swaps. These transfers are among three groups: shareholders, debtholders, and the swap counterparty. From this analysis we derive equilibrium swap rates and relate them to debt market spreads. We then show that equilibrium swaps in perfect markets transfer wealth from shareholders to debtholders. In a simplified case, we obtain closed-form solutions for the value of the default risk in the swap. For interest-rate swaps, we obtain numerical solutions for the equilibrium swap rate, including default risk. We compare these with equilibrium debt market default risk spreads.