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a series of promised cashflows, the payment of which depends upon
the probability that they will be paid. Other things being
equal, the probability that a payment will be made is greater in
the case of a counterparty with a high credit rating than in the
case of a counterparty with a low credit rating. Thus, all other
things being equal, the fair market value of the promise of the
higher rated counterparty is usually greater than the fair market
value of the lower rated counterparty. The midmarket value fails
to reflect this basic principle in that the value is calculated
without regard to a counterparty’s actual credit rating and
without regard to the presence or absence of credit enhancements
or netting.
Petitioner and its experts argue that the midmarket value of
an interest rate swap will always overestimate its fair market
value because, they assert, credit risk can only lower the swap’s
fair market value. We disagree. Credit risk in swaps is
bilateral and may increase or decrease midmarket value. For
example, all other things being equal, a swap’s midmarket value
is less than the actual value of FNBC’s position in the swap if
the counterparty has a better credit rating than FNBC. An upward
adjustment, therefore, is appropriate in such a case. A downward
adjustment, however, is appropriate in the converse situation.
The downward adjustment is necessary to reflect the fact that a
swap’s midmarket value is greater than the actual value of FNBC’s
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