This thesis presents a valuation model for the default risk of an interest rate swap to a riskless swap dealer. Previous studies evaluated the default risk of an interest rate swap by assuming that swap default probability is independent of interest rate movement. As this assumption is questionable, the present thesis evaluates the swap default risk by endogenously specifying the swap default probability in terms of the value of the firm which, in turn, is contingent on the interest rate. The default risk of a swap is measured in terms of the bid-ask spread of a matched interest rate swap, ignoring transaction costs. The bid-ask spread is computed by combining the default premiums of two separate swaps in a matched interest rate swap: one swap between the swap dealer and the fixed-rate paying end-user, and the other between the swap dealer and the floating-rate paying end-user. The default premium in a swap between the swap dealer and the fixed-rate paying end-user is computed by subtracting the fixed rate of a default-free swap from that of a comparable risky swap. The default premium in a swap between the swap dealer and the floating-rate paying end-user is computed by subtracting the fixed rate of a risky swap from that of a default-free swap. A path-dependent binomial model is used for computing the swap default premium in this thesis. The short-term interest rate is used as the underlying state variable on which the value of an interest rate swap is contingent. For a reasonable set of input values, the model developed in this thesis gives the numerical results which are close to the observed bid-ask spread in the market. It is found that the bid-ask spread is a decreasing function of the firm's cash flows, mean reversion speed of interest rates, and instantaneous term premium, and an increasing function of initial interest rates and interest rate volatility. The numerical results also show that as a firm enters into a swap contract, a wealth transfer occurs between equity holders and debtholders while the total value of the firm still remains the same.Ph.D.Business AdministrationUniversity of Michigan, Horace H. Rackham School of Graduate Studieshttp://deepblue.lib.umich.edu/bitstream/2027.42/105508/1/9135573.pdfDescription of 9135573.pdf : Restricted to UM users only
