Editing Interest rate swap (section)

==Risks==
{{further|Financial risk management#Investment banking}}
{{see also|Derivative (finance)#Risks|Corporate bond#Risk analysis}}
Interest rate swaps expose traders and institutions to various categories of [[financial risk]]:<ref name=PTIRDs /> predominantly [[market risk]] - specifically [[interest rate risk]] - and [[credit risk]].  Reputation risks also exist. The mis-selling of swaps, [[London Borough of Hammersmith and Fulham#Swaps controversy|over-exposure of municipalities]] to derivative contracts, and [[Libor scandal|IBOR manipulation]] are examples of high-profile cases where trading interest rate swaps has led to a loss of reputation and fines by regulators.

As regards market risk, during the swap's life, both the discounting factors and the forward rates change, and thus, per the above valuation techniques, the [[present value|PV]] of a swap will deviate from its initial value.   The swap will therefore at times be an asset to one party and a liability to the other.  (The way these changes in value are reported is the subject of [[IAS 39]] for jurisdictions following [[International Financial Reporting Standards|IFRS]], and [[FAS 133]] for [[U.S. GAAP]].) In market terminology, the [[first-order approximation|first-order]] link of swap value to interest rates is referred to as [[Greeks (finance)#Delta|delta risk]]; their [[Greeks (finance)#Gamma|gamma risk]] reflects how delta risk changes as market interest rates fluctuate (see [[Greeks (finance)]]). Other specific types of market risk that interest rate swaps have exposure to are [[basis risk]]s, where various IBOR tenor indexes can deviate from one another, and [[Repricing risk|reset risks]], where the [[Libor#Calculation|publication of specific tenor IBOR indexes]] are subject to daily fluctuation.

Uncollateralised interest rate swaps — those executed bilaterally without a [[Credit Support Annex|CSA in place]] — expose the trading counterparties to funding risks and [[counterparty risk|counterparty]] [[credit risk]]s.<ref name="investopedia">Cory Mitchell (2024). [https://www.investopedia.com/articles/optioninvestor/11/understanding-counterparty-risk.asp "Introduction To Counterparty Risk"], [[Investopedia]]</ref> Funding risks because the value of the swap might deviate to become so negative that it is unaffordable and cannot be funded.  Credit risks because the respective counterparty, for whom the value of the swap is positive, will be concerned about [[counterparty risk|the opposing counterparty defaulting]] on its obligations. Collateralised interest rate swaps, on the other hand, expose the users to collateral risks: here, depending upon the terms of the CSA, the type of posted collateral that is permitted might become more or less expensive due to other extraneous market movements.  Credit and funding risks still exist for collateralised trades but to a much lesser extent.  Regardless, due to regulations set out in the [[Basel III]] Regulatory Frameworks, trading interest rate derivatives [[regulatory capital|commands a capital usage]]. The consequence of this is that, dependent upon their specific nature, interest rate swaps may be capital intensive; with the latter, also, sensitive to market movements. Capital risks are thus another concern for users, and Banks typically calculate a [[credit valuation adjustment]], CVA  - as well as [[XVA]] for other risks - which then incorporate these risks into the instrument value.<ref>[https://worldscientific.com/doi/10.1142/9789813222755_0005 Valuing Interest Rate Swaps with CVA and DVA] Donald Smith (2017)</ref>

Debt security traders, daily [[mark to market]] their swap positions so as to "visualize their inventory" (see [[valuation control]]). 
[[Financial risk management#Banking|As required]], they will attempt to [[Hedge (finance)|hedge]], both to protect value and to reduce volatility.  Since the [[cash flow]]s of component swaps offset each other, traders will [[Hedge (finance)#Categories of hedgeable risk|implement this hedging]] on a [[Net (economics)|net basis]] for entire books.<ref>[https://fincyclopedia.net/derivatives/tutorials/hedging-a-swap Hedging a Swap], fincyclopedia.net</ref> Here, the trader would typically hedge her interest rate risk through offsetting [[United States Treasury security|Treasuries]] (either spot or futures).
For credit risks – which will not typically offset – traders estimate:<ref name="investopedia"/> 
for each counterparty  the [[probability of default]] using models such as [[Jarrow–Turnbull model|Jarrow–Turnbull]] and [[KMV model|KMV]], or by [[Root-finding algorithm|stripping these]] from [[Credit default swap#Probability modelp|CDS]] prices; 
and then for each trade, the [[potential future exposure]] and [[Credit valuation adjustment#Exposure, independent of counterparty defaul|expected exposure]] to the counterparty. 
[[Credit derivative]]s will then be purchased <ref name="investopedia"/> as appropriate.  
Often, a specialized [[Credit valuation adjustment#Function of the CVA desk|XVA-desk]] centrally [[XVA#Accounting impact|monitors and manages]] overall CVA and XVA exposure and capital, and will then implement this hedge.<ref>James Lee (2010). [https://web.archive.org/web/20120417014447/https://www.boj.or.jp/announcements/release_2010/data/fsc1006a5.pdf Counterparty credit risk pricing, assessment, and dynamic hedging], [[Citigroup Global Markets Japan|Citigroup Global Markets]]</ref>
The other risks must be managed systematically, sometimes [[Treasury management#Banks|involving group treasury]].

These processes will all rely on well-designed [[numerical methods|numerical]] [[financial risk modeling|risk models]]: both to measure and forecast the (overall) change in value, and to suggest reliable offsetting benchmark trades which may be used to mitigate risks.  Note, however, (and re [[PnL Explained#Sensitivities method|P&L Attribution]]) that the multi-curve framework adds complexity <ref name="CQF"/> in that (individual) positions are (potentially) affected by numerous instruments not obviously related.