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3. Credit Ratings of Both Counterparties
Petitioner argues that the fair market value of FNBC’s
interest rate swaps does not take into account FNBC’s own credit
rating. Respondent argues that the fair market value of interest
rate swaps takes into account both parties’ creditworthiness. We
agree with respondent. We believe that a determination of the
fair market value of interest rate swaps, in that they are
bilateral contracts which by definition require the performance
of both parties thereto, must take into account the
creditworthiness of both of those parties. FNBC’s credit risk
methodology ignores the bilateral nature of swaps and the impact
that FNBC’s own credit risk has on a swap’s fair market value
flowing from the danger that FNBC may not fulfill its obligations
under the swap.
We agree with Duffie and Parsons that the credit rating of a
dealer such as FNBC affects the value of a swap. We also agree
with Duffie and Parsons that the credit adjustment may be either
positive or negative when a counterparty has a better credit
rating than the dealer, regardless of that higher rating. As
Parsons stated, a dealer such as FNBC may have to make an upward
adjustment if a swap becomes significantly off-market to the
dealer’s disadvantage, regardless of who has the higher credit
rating. In that case, the counterparty is exposed to credit risk
from the dealer, and the dealer is generally not exposed to any
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