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counterparty has the lower credit rating and (2) the parties to
the swap have not agreed to any credit enhancement that would
negate that lower rating. Respondent asserts that any credit
adjustment that is reported under section 475 must be ascertained
on the basis of a market benchmark, which is not present here.
We hold that a credit adjustment to the midmarket value of
an interest rate swap is necessary in certain cases to determine
the swap’s fair market value. Specifically, we hold that such an
adjustment is required to the extent that the adjustment properly
reflects the change to the swap’s midmarket value on account of
the actual parties’ respective creditworthiness, taking into
account all the facts and circumstances that would enhance or
diminish each party’s creditworthiness.76 We consider the
presence or absence of credit enhancements such as collateral or
netting provisions to be an important factor to take into account
as to the enhancement or diminution of a counterparty’s
creditworthiness.
We hear from all of the experts on financial derivatives
that credit risk may cause a swap’s fair market value to deviate
from its midmarket value and, therefore, that the fair market
value of a swap should reflect credit risk. We agree. A swap is
76 Given our conclusion that we must value each swap on the
basis of the traits of the actual parties thereto, we disagree
with respondent that a market benchmark as to credit adjustments
is indispensable to the determination of any such adjustment.
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