The Market Value and Dynamic Interest Rate Risk of Swaps

Andrew H. Chen and Mohammed M. Chaudhury

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: At the time of initiation, interest rate swaps are of zero market value to the counterparties involved. However, as time passes, the market value of the swap position of each counterpart may become positive or negative. These value changes are stochastic in nature and are primarily driven by stochastic variations of the term structure of interest rates. In this paper, we develop models for determining the market values and dynamic interest rate risks of existing swap positions using the one-factor general equilibrium term structure model of Cox, Ingersoll, and Ross (1985). The valuation and risk measurement framework of this paper should be useful in developing a value turn risk accounting method advocated by Merton and Bodie (1995) for better internal management and reporting purposes and for more effective regulation.

This paper was presented at the Financial Institutions Center's October 1996 conference on "

Date: 1996-02
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