Question

“Companies with high credit risks are the ones that cannot access fixed-rate markets directly. They are the companies that are most likely to be paying fixed and receiving floating in an interest rate swap.” Assume that this statement is true. Do you think it increases or decreases the risk of a financial institution’s swap portfolio? Assume that companies are most likely to default when interest rates are high.

Answer 1

Answer:

The companies having high credit risks are preferred floating interest rate as these companies taking high risk and wanted to take benefit as per market conditions. These companies take benefit of the floating interest rate fluctuation as interest rate changed in the market. These companies generally have floating interest rate rather than fixed interest rate.Due to floating rate it has high risk with company.

In interest rate swap two companies are involved. One has Fixed Interest rate and one has floating interest rate.

These both companies entered into contract to take a benefit of the interest rate . The company having  floating interest rate swaps with the fixed interest rate along with some margin to pay. and other company swaps with floating rate along with the margin. It reduces the burden of Interest on loan for both companies. It decreases the risk to the companies having high risk.

In given situation the companies with high credit risks are the ones has to pay floating interest rate , but due to interest rate swap they pay as per fixed interest rate with margin , which reduces there risk.

It certainly affects the risk of financial institution's swap portfolio , as interest rate risk decreases, it reduces the risk of default as in the situation the companies liability reduces and the risk of default also be reduced.

The default of loan is a very subjective and situational. It depends on the organisation and it's situation at that time of default. Here we need to consider that Interest rate swap reduces the credit risks but it may or may not cause of the reducing the default. It depends on the company to company. Company having low interest rate can default and company having high interest rate paid the entire liability of loan. It depends on the situation and credit capacity of the company as per time to time.