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should play no role in the fair market values at which
it trades.
The petitioner’s expert analysis suggests that
Silver should make a downward credit adjustment in
market value (from zero) associated with the potential
default of counterparty Z, disregarding its own lower
credit quality. Again, this is incorrect. The
petitioner’s experts rely on the argument that if the
low-quality dealer Silver were to attempt to “sell”
(that is, assign its position in) its swap with Z to
the higher-quality dealer Gilt, then Gilt “would not be
influenced to pay more or less” because of Silver’s
credit rating, because, if it purchased this swap from
Silver, it would not be extending credit to Silver.
* * * There is a logical fallacy here. Silver had
already been receiving, in terms of expected credit
exposure, an effective extension of credit from Z,
which was worth P to Silver, net of the value of the
effective credit it had offered Z. If Silver were to
ask Gilt to assume its position in the swap, it would
demand P in return for the net loss in market value on
the extension of credit by Z. Then, before completing
the deal with Silver, Gilt would turn to counterparty Z
and ask for an up front payment of P in return for
relieving Z of its net exposure to Silver, in the event
that the re-assignment of the swap from Silver to Gilt
were to occur. Since Z would indeed benefit from this
net reduction in credit risk that is worth P, Z would
agree to pay P to Gilt, contingent on the re-
assignment. All three parties would then consummate
the trade. Gilt would now be paying a fixed rate R to
Z on a fixed-for-floating swap, and have gotten into
this contract for a net price of 0. This is of course
the same price (zero) at which Gilt and Z would have
signed the swap contract in the first place. Of
course, there is some doubt in practice whether all
three counterparties would take the trouble to make
such contingent assignment arrangements, and indeed it
is unusual to see swap assignments, where there is a
material difference in the credit qualities of the
assignor and assignee. This does not lessen the “moral
of the story,” which is that Silver’s own credit
quality does indeed play a role in determining the
market value of its swap with Z.
Now, going back to the swap between Z and the low-
quality dealer Silver, suppose that interest rates fall
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