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FRM Exam Part I · Swaps

Swap Credit Risk and Other Swap Types for FRM Part I

Updated 11 October 2026 · Fact-checked

Swap credit risk is the chance a counterparty defaults when the swap has positive value to you. Only the positive value is at risk, and it changes over time. Other swap types, such as equity, commodity, credit default and amortizing swaps, change what is exchanged but follow the same logic: swap payoffs, then value them.

Understand Swap Credit Risk and Other Swap Types

A swap is a contract to exchange cash flows. Because it is usually traded over the counter, each side faces the other's default risk. This is counterparty credit risk.

Credit risk in a swap differs from credit risk in a loan. In a loan, the lender advances principal and the whole amount is at risk. In a swap, usually no principal is exchanged, and the exposure is the swap's replacement cost. Exposure is max(V, 0), where V is the value of the swap to you. If V is negative, you owe money and your exposure to the counterparty is zero. Exposure is also two-sided: the value can flip sign as rates or prices move, so either party may be the one at risk.

Exposure changes over time. At inception, a fair swap has a value of about zero. As time passes, uncertainty about market moves grows, which raises potential exposure. But payments are made and fewer cash flows remain, which lowers exposure. So for an interest rate swap, expected exposure typically rises first and then falls toward maturity (a hump shape). For a currency swap, the final exchange of principal makes exposure larger, and it tends to be higher near maturity than for an interest rate swap.

Netting and collateral reduce exposure. Under a netting agreement, all swaps with one counterparty are combined, so exposure is max(sum of values, 0) instead of the sum of the positive values. Collateral under a credit support agreement offsets the remaining exposure.

Other swap types change the underlying. An equity swap exchanges the return on a stock or index for a fixed or floating rate. A commodity swap exchanges a fixed price for a floating commodity price on set quantities. A credit default swap pays out on a credit event in return for a periodic premium. An amortizing swap has a notional that declines on a schedule, and a basis swap exchanges two floating rates, such as one tenor of a rate for another.

Key formulas to remember

Credit exposure of a swap
Exposure = max(V, 0)
V is the swap's value to you. Only a positive value is lost if the counterparty defaults.
Netted exposure
Netted exposure = max(V1 + V2 + ... + Vn, 0)
Applies only if a legally enforceable netting agreement covers all the trades.
Exposure after collateral
Net exposure = max(V − Collateral held, 0)
Ignores thresholds, minimum transfer amounts and the margin period of risk.
Expected credit loss
Expected loss = PD × LGD × Exposure
Use expected exposure at default. Loss given default (LGD) = 1 − recovery rate.
Amortizing swap payment
Payment in period t = Rate × Notional outstanding at the start of period t
Notional falls on the schedule, so payments fall too.

How to solve Swap Credit Risk and Other Swap Types questions

Use this method for any question on swap credit risk or a swap variant.

  1. 1Identify the swap type and what each side pays and receives.
  2. 2Work out the current value V to you. Use the fixed-versus-floating or the leg-by-leg PV.
  3. 3Convert to exposure: max(V, 0). Zero if V is negative.
  4. 4Apply netting first (sum the values, then take the max), and then subtract collateral.
  5. 5If asked for expected loss, multiply PD, LGD and the exposure.
  6. 6For variants, adjust the notional schedule or the underlying: use the notional outstanding for amortizing swaps, and the index return for equity swaps.
  7. 7Check the direction: who is at risk, and does the answer make sense when V changes sign?

Quickest way: Positive value, then netting, then collateral

When to use it: Use for any multiple-choice item that asks who bears credit risk or how much exposure remains.

  1. Ask: is the swap an asset to me? If not, exposure is zero.
  2. If several trades are netted, add the values before taking the max.
  3. Subtract collateral, and floor at zero.
  4. For shape questions, remember: interest rate swap exposure is a hump, and currency swap exposure rises toward maturity.
  5. For loan comparisons, remember: swap exposure is only replacement cost, never the notional.

Common mistakes in Swap Credit Risk and Other Swap Types

  • Treating the notional as the amount at risk.

    Students carry over the loan idea that the principal is lent.

    Fix: In an interest rate swap the notional is not exchanged. Only the net value of the swap is at risk.

  • Counting a negative value as a loss to the counterparty's default.

    Students forget exposure is one-sided.

    Fix: Use max(V, 0). If V is negative, your credit exposure is zero.

  • Summing exposures instead of netting values.

    Students take the max trade by trade.

    Fix: When netting applies, add the values first and then take the max. It is never larger than the sum of positive values.

  • Saying swap exposure always falls over time.

    Students think only of the shrinking number of payments.

    Fix: Uncertainty grows while remaining payments shrink. For interest rate swaps, exposure rises and then falls.

  • Mixing up the amortizing swap and the basis swap.

    Both sound like adjustments to a plain vanilla swap.

    Fix: Amortizing means the notional declines. Basis means floating is exchanged for floating.

Worked examples

Example 1

A bank has three swaps with one counterparty under an enforceable netting agreement. The values to the bank are +$4.0 million, +$2.5 million and −$3.0 million. The bank holds $1.0 million of collateral. What is its net credit exposure?

Show the solution
  1. Sum the values: 4.0 + 2.5 − 3.0 = $3.5 million.
  2. Apply the max: max(3.5, 0) = $3.5 million.
  3. Subtract collateral: 3.5 − 1.0 = $2.5 million.

Answer: $2.5 million

Example 2

A counterparty has a one-year PD of 2% and a recovery rate of 40%. The expected exposure at default on a swap is $5 million. What is the expected credit loss?

Show the solution
  1. LGD = 1 − 0.40 = 0.60.
  2. Expected loss = PD × LGD × Exposure.
  3. = 0.02 × 0.60 × 5,000,000.
  4. = 0.012 × 5,000,000 = $60,000.

Answer: $60,000

Exam tips

  • Exam items often ask who bears the risk. Check the sign of V before anything else.
  • Know the exposure profile shapes: a hump for interest rate swaps, and rising toward maturity for currency swaps.
  • When netting is mentioned, add the values first. Do not take the max trade by trade.
  • Know one-line definitions of equity, commodity, credit default, amortizing and basis swaps. Definition questions are quick marks.
  • Be able to explain why swap credit risk is lower than loan credit risk of the same notional.

Practice questions from Swaps

Swap Credit Risk and Other Swap Types in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Swap Credit Risk and Other Swap Types: frequently asked questions

What is the difference between the credit risk of a swap and of a loan?

In a loan, the lender advances principal, so the full amount is at risk. In a swap, usually no principal is exchanged, and only the positive replacement value is at risk. Swap exposure is also two-sided, because the value can change sign.

How does counterparty risk affect swap value?

It lowers the value of a swap to the party that is exposed. The adjustment for it is called the credit valuation adjustment (CVA), which is roughly the expected loss from the counterparty's default. The risk-free value less CVA gives the value after credit risk.

What is an equity swap?

An equity swap exchanges the return on a stock or an index for another return, often a fixed or floating interest rate. One side pays the equity return, including dividends and price changes, and the other pays the rate on the notional.

What is an amortizing swap and what is a basis swap?

An amortizing swap has a notional that declines over time, which suits loans that are repaid in instalments. A basis swap exchanges two floating rates, for example floating rates of different tenors or indices.

Does a commodity swap carry credit risk?

Yes. One side pays a fixed price and the other a floating price for a set quantity. The party with a positive value is exposed to the other's default.