Interest Rate Swap Valuation since the Financial Crisis: Theory and Practice

The financial crisis of 2007-09 revealed the importance of counterparty credit risk in the valuation of non-collateralized interest rate swaps. In theory, these valuations rest on assumed default probabilities and recovery rates. These assumptions, however, should be reflected in the risk-adjusted discount rates of the counterparties. Thus, in practice, swap valuations can be generated by discounting prospective swap settlements using risk-adjusted discount rates, cash flow by cash flow. This article demonstrates this method, discerning risk-adjusted discount rates from data that are readily available on the Bloomberg information system. Critically, if the inputs for the two methodologies are mutually consistent, theory and practice should yield identical valuations.