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dramatically, and the swap has moved so far into the
money (of positive value) to Silver, that Silver now
has an expected exposure to Z that is so large as to
cause an expected loss from default by Z that is much
larger than the expected loss to Z from default by
Silver, resulting in a new credit adjustment in
Silver’s market value that is downward.
That is, the same swap between the same two
counterparties can have an upward adjustment for credit
risk in some cases, and a downward credit adjustment in
other cases, regardless of the relative quality of the
counterparties. At the inception of a swap with no
initial exchange of cash flow, however, a dealer of
lower credit quality than its counterparty should not
apply a downward credit adjustment relative to a mid-
market valuation. If anything, the adjustment from
mid-market should be upward.
I have not learned of cases in which major dealers
have actually made upward credit adjustments from the
mid-market valuation of interest-rate swaps associated
with the fact that their own credit quality is lower
than that of their counterparty. Dealers are normally
of high quality in any case. When dealers (and other
firms) issue bonds, however, they sell them to
investors at a price that reflects their own credit
quality. The lower their quality, the lower the price
at which they are willing to issue their bonds,
relative to those issued by higher-quality firms. The
same principle applies to derivatives.
4. Midmarket Values Reflected AA Counterparties
Parsons stated that for a counterparty rated AA, the credit
risk is already reflected in the discount rate used to calculate
midmarket value. Parsons also stated that applying a credit
adjustment on a swap negotiated with an AA counterparty is double
counting absent the presence of an incremental credit risk above
and beyond that already reflected in the quoted AA swap rates.
Such an incremental credit risk could occur if the swap becomes
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