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Although the notion of midmarket adjustments for credit risk
was recognized in the swaps market, there was no publicly
available data as to the impact that credit quality had on swap
prices. The publicly reported bid and ask rates were commonly
considered valid for counterparties rated AA, and counterparties
with other ratings that negotiated around these quotes did not
publicly report the prices which they negotiated. Those
negotiated prices, therefore, could not be distilled into a set
of swap curves for different credit qualities.
2. Common Method of Calculating Adjustment
There was no consensus during the relevant years about
either the model or the methodology that should be used to
calculate a credit adjustment on swaps. Many bank dealers
calculated their credit adjustments on the basis of a formula
that referenced (1) each counterparty’s credit rating, (2) the
bank’s estimate of expected losses for that credit rating, and
(3) a loan equivalency amount.
a. Counterparty Credit Rating
Most bank dealers had well-established internal credit
risk-rating systems which were developed for purposes other than
calculating a credit adjustment on a swap. Many dealers applied
these credit ratings to ascertain their credit adjustments for
swaps.
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