Pricing of swaps with default risk

In this paper, I study the valuation of interest rate and currency swaps with default risk under the contingent claim analysis framework. I demonstrate that the traditional approach of pricing swap contracts as exchanges of loans underestimates the value of such contracts to the counterparty with higher credit rating and exaggerates the credit spread required to guard against default risk. Numerical simulations show that the swap rate is not sensitive to counterparty credit rating: for a ten year interest rate swap, a one hundred basis point increase in counterparty bond yield spread results in only about one basis point increase in the swap rate. © 1998 Kluwer Academic Publishers,.