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swaps. The reasons for buyouts were generally that one of the
counterparties had a business need to terminate the transaction
or was in distress. Swaps were bought out (and initially entered
into) on a swap-by-swap (rather than portfolio) basis.
G. Risks Assumed by Dealers
1. Types of Risks
Dealers entering into interest rate swaps assumed at least
two types of risk; namely, a credit risk and a market risk.
Credit risk was the risk of loss from the possibility that the
counterparty would not perform and would default on its payment
obligations. Market risk was the risk that changes in the market
would affect the value of an instrument. The most common form of
market risk was interest rate risk.
2. Techniques Used To Minimize Credit Risk
During the relevant years, the practice of rationing credit
risk exposure to specific counterparties through credit
enhancements was widespread and was an important part of credit
risk management. In addition to placing limitations on the tenor
and principal amount of a swap, swaps dealers such as FNBC
required counterparties with lower credit quality to post
collateral to support the counterparties’ obligations under the
contracts. Dealers such as FNBC (and end users) also sometimes
inserted provisions in the underlying contracts requiring
maintenance of a specified debt-equity ratio, a net worth
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