Spreads of rates on interest rate swaps over comparable U.S. Treasury yields widened dramatically during the acute financial market turmoil that followed the Russian default crisis of 1998. While a significant portion of that widening in swap spreads likely reflected increased concerns about credit risk in general and greater demand by investors for the safety and liquidity of Treasury securities corporate bond and LIBOR spreads over Treasuries had also moved substantially higher it is conceivable that swap spreads were also affected by market participants’ worries about counterparty credit risk in swaps. This paper examines a well known no arbitrage relationship between interest rate swaps and eurodollar futures contracts to take a novel look at this issue. In particular, I examine whether the spread between swap rates quoted by dealers and “synthetic” swap rates implied by the futures market where counterparty credit risk is virtually absent provided any indication that swap rates were signaling heightened concerns about counterparty risk in the swaps market at that time.

Understanding the potential role that concerns about counterparty credit risk play in the pricing of interest rate swaps during times of financial market stress is important for at least two reasons. First, while a vast academic literature has studied the issue both from a theoretical and an empirical perspective, existing studies have not assessed the robustness of their findings to episodes of turmoil in the financial markets. Second, the interest swap market has been increasingly taking on a benchmark role in the broader fixed income market that had previously virtually been the exclusive domain of U.S. Treasury debt securities. Given its greater prominence for the financial markets as a whole, the question of assessing the ability of the swaps market to continue to function without major impediments such as heightened concerns about counterparty credit risk—when other (less liquid) markets are disrupted gains special significance for academics, market practitioners, and policymakers alike.