The Default Risk of Swaps

Ian A Cooper and Antonio S Mello

Journal of Finance, 1991, vol. 46, issue 2, 597-620

Abstract: The authors characterize the exchange of financial claims from risky swaps. These transfers are among three groups: shareholders, debtholders, and the swap counterparty. From this analysis, the authors derive equilibrium swap rates and relate them to debt market spreads. They then show that equilibrium swaps in perfect markets transfer wealth from shareholders to debtholders. In a simplified case, the authors obtain closed-form solutions for the value of the default risk in the swap. For interest-rate swaps, they obtain numerical solutions for the equilibrium swap rate, including default risk. The authors compare these with equilibrium debt market default risk spreads. Copyright 1991 by American Finance Association.

Date: 1991
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