A bank purchases an interest rate swap, exchanging a fixed interest rate of 8% for a floating interest rate of LIBOR + 120 basis points, on a notional principal of £200mn. There is no arrangement fee. If the counterparty were to default, could the bank lose the £200mn? Explain why the bank is exposed to credit risk from holding this swap if short term interest rates rise, but is not exposed to credit risk if short term interest rates fall. Explain with examples the use of netting, and of margining, to reduce counterparty risk.
The question belongs to Finance and it discusses about a bank being exposed to credit risk from holding a swap with short term interest rates rising but not exposed to credit risk.
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