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Pricing Defaultable Swap Interest rate swap are quoted irrespective of credit ratings of counterparties. In another words, they are considered as default-free. However, swap contracts are traded over-the-counter (OTC) and are not backed by the guarantee of a clearing corporation or an exchange. As a consequence, each party is exposed to the credit risk (default risk). Historical experience shows that credit risk often leads to significant losses. Therefore, one should incorporate the cost of the counterparty risk into the swap price. Also, regulatory issues related to the Basel II framework encourage the inclusion of default risk into valuation. The object modeled under the market models is risk-observable. It is also consistent with the market standard approach for pricing caps/floors using Black’s formula. The market models have now become some of the most popular models for pricing such derivatives. They are generally considered to have more desirable theoretical calibration properties than short rate or instantaneous forward rate models. Unlike structural models, reduced-form models do not condition default explicitly on the value of the firm, and parameters related to the firm’s value need not be estimated to implement the model. For pricing and hedging, reduced-form models are the preferred methodology. Our closed-form solution shows that the value of a bilateral defaultable IRS is the sum of the values of individual bilateral defaultable swaplets. Each bilateral defaultable swaplet can be replicated by buying a risk-adjusted call option and selling a risk-adjusted put option. The risk-adjusting factors depend on hazard rates, recovery rates and settlement rules. In the case where the floating-rate payer is a LIBOR party, we confirm findings that the swap spreads are relatively less sensitive to credit quality comparing to the bond spreads or the CDS spreads. The credit impact on swap rates is approximately linear. In the case where both parties have spreads against the LIBOR that was not studied closely before, we find that the credit impact on swap rates is not linear any more. The swap funding spreads have a significantly impact on swap spreads as well. Pricing Defaultable Swap |