Question 3

Does the value of an interest rate swap in particular, and derivatives in general, depend on who the counter party is and whether the contract is collateralized?

The value of an interest rate swap and the derivatives in general is dependent on who the counter party is because the counter party determines the level of the counter party risk in the derivative transaction. Counterparty risk is the risk of default by the counterparty in the various forms of the derivative contracts that are formed(Johannes, 2007). A derivative or the interest rate swap is a contractual agreement between two parties that can be broken by either of the party and thus both the parties to the transaction are exposed to the risk.

For instance, an over the counter option is sold by Bank A to Customer D. Then the counter party risk would be that either Bank A or the customer D defaults. If we assume that Bank A defaults in the obligation to Customer D as a result of bankruptcy, then this would surely impact on the position of the contract on the customer. The rates are also defined based on the level of the counter party risk inherent in a specific interest rate swap agreement and other derivate contracts. Therefore, the value of an interest rate swap in particular, and derivatives in general, depend on who the counter party is.

Moreover, the collateralization of an interest rate swap or derivative contracts has an impact on the instrument rates. For instance, collateralization has an impact on the swap rate (Johannes, 2007). The collateralization within the swap agreements questions the mark to market practice and new intermediate cash flows are introduced and they also alter the credit characteristics. Furthermore, the collateralized interest rate swaps expose the parties to many collateral risks. The collateral can also become less or more expensive for the parties depending on the credit support annex and also due to the extraneous market movements(Henrard, 2014)………………….

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