A recursive algorithm for default risk adjustment in interest rate swaps

This paper provides empirical evidence on the cross-sectional and time-series variation for the pricing of contracts that swap fixed- for floating-rate interest payments in eight international markets. Swap spreads defined as the difference between the fixed swap rate and the yield of a risk-free security of equal maturity are analyzed across markets. A framework, which allows to assess the ability of asymmetric default risk to generate observed spreads, is introduced and used to simulate default risk-adjusted swap rates. For typical yield curve and default conditions asymmetric default risk cannot generate positive swap spreads of the magnitude found in the data. These results are unchanged when incorporating expected or realized LIBOR spreads in the analysis. Copyright (C) 1998 IFAC.