For a 10 year interest rate swap, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)

For a 10 year interest rate swap, what would be the worst time for a counterparty to default (in terms of the maximum likely credit exposure)
A . 10 years
B . Right after inception
C . 2 years
D . 7 years

View Answer

Answer: D

Explanation:

Right after inception’ is incorrect as the interest rate swap (IRS) would be valued at close to zero right after inception and the credit risk would be minimum. Choice ‘a’ (ie 10 years, at maturity) is incorrect as at maturity there would be no more cash flows to exchange, and the replacement value of the contract would again be close to zero.

Therefore the worst time for the counterparty to default is somewhere between inception and maturity – in fact the range of possible outcomes for the contract increases with the passage of time, and we should find the worst time to default to be a later date. However, towards maturity, the value of the contract starts to go towards zero again, and the maximum value is reached around 7 years. 2 years is too early for the maximum to be reached for the10 year IRS, and therefore choice a is the correct answer.