The cost to corporates for interest rate and foreign exchange swaps could increase as more firms plan to use credit derivatives to hedge counterparty risk on these transactions. Interest-rate and foreign exchange desks at Bank of America, Lehman Brothers and UBS Warburg are looking at entering credit derivatives to price swaps more accurately and increase their credit lines. The move is spurred by the general deteriorating credit quality of corporates, said firm officials. The exact impact on swap pricing could not determined, one banker said pricing could even improve for highly-rated credits.
The increase in cost for corporates would depend on where credit-default protection is trading, said one banker. But, "Pretty much every bank is looking at the way they price and charge for contingent counterparty risk," said Rob O'Rahilly, v.p. in credit portfolio trading at JPMorgan in London. Although some firms, such as JPMorgan and Deutsche Bank, already use credit derivatives in this capacity, a majority of swap houses do not.
Firms already factor in the cost of credit by charging a spread over LIBOR but this rate could either increase to the level of default protection or firms could quote a separate credit charge. When a derivatives house enters a swap with a corporate it can hedge the risk of default using a credit-default swap and a trigger that is defined as the company failing to pay the swap. This is different than a typical credit-default swap where there are several triggers and the buyer of protection has to deliver the defaulted instrument.
The hedge needs to be actively rebalanced if the foreign exchange or interest rate exposure changes, requiring dedicated resources, such as traders and pricing tools, explained Rashid Zuberi, director and co-head of interest-rate derivatives structuring at Deutsche Bank in London. That will add to the cost to be passed on to the client.
Bank of America is setting up a specific team to isolate, trade and hedge this contingent risk, said Alex Bernand, director in structured credit trading in London. Lehman already does this on certain transactions, but is contemplating doing it in a more systematic manner, said a Lehman official. Officials at UBS declined comment.
Similarly, Dresdner is actively looking at new ways to hedge counterparty risk using credit derivatives, such as laying off that risk in a collateralized debt obligation, said Stratis Hatzistefanis, head of structured credit products.
