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credit risk from the counterparty. On the other hand, Parsons
stated, the dealer may have to make a downward credit adjustment
if the swap becomes significantly off-market to the dealer’s
advantage, regardless of the relative credit ratings of the
dealer and its counterparty.
Duffie disagreed with the related analysis of petitioner’s
experts that rested on the premise that only the credit quality
of the dealer’s counterparty should be considered when making a
credit-risk adjustment, and that the relative quality of the
dealer itself is irrelevant. Duffie stated:
consider the case of interest-rate swaps, with two
possible dealers, Gilt and Silver, and an outside
counterparty, Z, that wishes to pay the floating rate.
We will ignore all adjustments except for credit.
Suppose the outside counterparty X is rated AA, that
Gilt is rated AA, and that Silver is rated BBB.
Suppose Z calls Gilt and asks for the fixed rate R to
be paid by Gilt that would be set so that there is no
initial exchange of cash, meaning that the fair market
value of this swap between Z and Gilt is zero.
Now, suppose Z calls the lower-quality dealer
Silver in order to obtain an interest rate swap under
which Z pays floating and Silver pays the same fixed
rate R. They negotiate a price P for this swap (under
the same standard of willing buyer and seller used in
the definition of “fair market value”) to be paid by
Silver to Z. The price is greater than zero because Z
was willing to receive a price of zero under the same
contractual terms when trading with the higher-quality
dealer Gilt. He would be unwilling to trade at a price
of zero with Silver, but rather would demand some
higher price as compensation for bearing the comparably
higher credit risk of Silver. This means an upward
adjustment in the market value of the swap to Silver,
relative to the price of zero obtained by Gilt. This
refutes the claim that Silver’s own credit quality
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