Swap credit risk covers only net interest differences because principal is notional

Evidence

Any “credit risk” (risk of default) associated with swap-spread arbitrage like the trade in appendix G is typically small. The risk of the U.S. government’s defaulting on its bonds is regarded as negligible; bond futures contracts are guaranteed by the clearinghouse of a derivatives exchange such as the Chicago Board of Trade; and LTCM’s swap contracts were typically with major banks. Even major banks may fail, but because the principal sum in a swap is not exchanged, it is only notional and is at no risk: the credit risk involved is only of the loss of future net differences between fixed-rate and floating-rate interest. — Donald MacKenzie, An Engine, Not a Camera, 984

Categorization

• DEFINE: Explains why swap counterparty credit risk is limited to net interest flows, not principal.
• XREF: Connects to the mechanics of swap-spread arbitrage structurally relevant to LTCM risk analysis. — connects to: Derivatives differ from assets in being zero-sum trades for the parties — Mark Blyth, Austerity: The History of a Dangerous…, 705; Buying bonds and paying fixed in a swap nets a small positive cash flow. — Donald MacKenzie, An Engine, Not a Camera: How Financial…, 1299

Broader Connections

• Derivatives differ from assets in being zero-sum trades for the parties #expands (0.75) — Mark Blyth, Austerity, 705