Swap Pricing with Two-Sided Default Risk in a Rating-Based Model

This paper analyzes the pricing of defaultable securities in rating based models where the default of more than one agent is involved. We extend the model of Duffie and Huang (1996) to a framework which explicitly takes into account the rating of each party. Although our method is by no means restricted to swap contracts we will use as our illustrative example a plain vanilla interest rate swap.1 Our extension allows us to investigate the effects on swap spreads of early termination provisions, i.e., credit triggers, which are linked to the ratings of the contracting parties. Clearly, a credit trigger will make each counterparty look less risky, as illustrated for example in Wakeman (1996), simply because the trigger eliminates those defaults that occur after a sequence of downgrades. How much this affects swap spreads can be studied using the technique presented in this paper. We also consider the following questions: • How does the degree of rating asymmetry affect swap spreads? • How does the swap spread vary with rating when the two parties have the same rating?