A bank enters into an interest rate swap with a nonfinancial counterparty using bilaterally clearing where it is paying a fixed rate of 3% and receiving LIBOR. No collateral is posted and no other transactions are outstanding between the bank and the counterparty. What credit risk is the bank subject to? Discuss whether the credit risk is greater when the yield curve is upward sloping or when it is downward sloping.

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Q: refinancing rate

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Swaps

A swap is a derivative contract in which two parties are agreed to exchange their cash flows from two different financial instruments for a defined period. In swap contracts, cash flows from one financial instrument are fixed and cash flow from other financial instruments is variable based on the interest rate, exchange rate, and commodity price. Swap contracts are transacted in an over-the-counter system. Swap contracts are utilized to hedge risk and mitigate loss.