Cooper is Associate Professor of Finance at the London Business School. Mello is Assistant Professor of Finance at MIT. We are grateful to participants at workshops at Bristol University, Cambridge University, HEC, London Business School, LSE, MIT, and Warwick University for comments. We are especially grateful to Dick Brealey, Bernard Dumas, Michael Selby, René Stulz, and two anonymous referees for suggestions.
The Default Risk of Swaps
Article first published online: 30 APR 2012
1991 The American Finance Association
The Journal of Finance
Volume 46, Issue 2, pages 597–620, June 1991
How to Cite
COOPER, I. A. and MELLO, A. S. (1991), The Default Risk of Swaps. The Journal of Finance, 46: 597–620. doi: 10.1111/j.1540-6261.1991.tb02676.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
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.