Series 50: Risks

Risks

Interest rate swaps carry other risks, as well.

Counterparty risk. This is the risk that the counterparty in a swap agreement will default on its payments. This is also the risk that the counterparty’s credit quality will decline so much that the market will fear that it will default on its payments. When a municipality enters into a swap agreement, it is exposing bondholders to counterparty risk that didn’t exist before the agreement was signed.

Basis risk. This is a risk that applies to basis swaps only. Recall that a basis swap is when two variable rates are swapped. Basis risk is when the variable rate paid by the issuer to its bondholders differs from the swap rate. This can happen when the floating rate of the bond is based on a different index than the floating swap rate. One might be based on LIBOR, for example, and the other on the Securities Industry and Financial Markets (SIFMA) rate.

Termination risk. Some swap ag