Scope and method of study. The purpose of this study was to measure the systemic risk in the interest rate swap market and address regulatory policy issues aimed at mitigating systemic risk in this market. A model of systemic risk was developed using the stylized facts observed in the interest rate swap market. The model consisted of four components: the term structure model, the firm value model, the swap dealer capital model and the recovery rate model. The probability of a systemic repercussion occurring in the interest rate swap market was taken to be the measure of systemic risk in this market. The model was simulated using the Monte Carlo simulation methodology.; Findings and conclusions. The expected probability of a systemic repercussion in the interest rate swap market was found to be small at 0.72% over the ten year time frame of the simulation. The sensitivity of the probability of a systemic repercussion to the parameters of the model was examined. The probability of a systemic repercussion was found to be most sensitive to the default threshold, which indicates default when the firm value falls below it. Three factors, namely, calculation of potential credit exposure, capital requirements and swap portfolio diversification, which the regulators have control over, were analyzed to examine their effect on the probability of a systemic repercussion. The federal reserve's current recommendation for calculating potential credit exposure was found to understate the credit exposure. It was found that the systemic risk reduced with increasing capital requirements and the reduction was small when the capital ratio was increased beyond 14%. Hence, it was recommended that the federal reserve consider raising the capital ratio to 14% from the current level of 8%. It was also found that there was significant reduction in the probability of a systemic repercussion when the swap portfolio was well diversified in terms of tenor and counterparty. Hence, it was recommended that the federal reserve consider placing a restriction on how diversified the swap portfolio of a swap dealer should be in terms of tenor and counterparties. These recommendations were made without taking into account the cost of into account the cost of imposing the regulations.
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