The primary risk for Swapco is that of counterparty default. Swapco operates with rela-
tively few hard restrictions regarding gross or net exposures of counterparties based
on the rating of counterparties. Instead, as Swapco's capital formula implies, the in-
centive to transact with a given counterparty depends on the associated capital
charge, which, in turn, depends on the counterparty's rating. A counterparty rated at
the time a transaction is entered into must at least be of investment-grade (Baa3 or
higher) status. Net exposure to unrated counterparties and to counterparties subse-
quently downgraded below investment grade will be capitalized at 100% of the net
mark-to-market exposure by SBHC. Should Swapco's net exposure to noninvestment
grade and unrated counterparties represent more than a specified percentage of
Swapco's total capital, while Moody's commercial paper rating for Salomon Inc is
below Prime-1, this net exposure will be capitalized at a higher rate. In the event that
Swapco's net exposure to noninvestment-grade and unrated counterparties repre-
sents a high proportion of Swapco's total capital, while Moody's commercial paper rat-
ing of Salomon Inc is below Prime-1, this net exposure will be capitalized at an even
higher rate. Any time Swapco enters into a transaction with a counterparty that has not
been assigned a rating by Moody's, Swapco shall submit that counterparty to Moody's
for approval. Once the counterparty is classified as an Approved Counterparty, the
counterparty will be included with counterparties carrying a Baa3 rating for purposes
of the Minimum Required Capital formula. If the counterparty is not approved, the net
mark-to-market exposure to Swapco will remain fully capitalized.
Since SBHC will act as counterparty for about half of all Swapco transactions,
Swapco's exposure to SBHC is potentially large. Swapco will therefore hold collateral
posted by SBHC to protect against a possible default by SBHC in an amount equal to
100% of Swapco's net mark-to-market exposure to SBHC.
In the event that Swapco is terminated, either because of the bankruptcy of Swapco,
SBHC, or Salomon Inc, or because of the failure to meet capital, collateral, or liquidity
requirements, Swapco will be exposed to additional risk of market changes in its expo-
sure to SBHC. That risk will be present until Swapco's book can be valued. The termi-
nation process should require no more than eight days and is likely to be completed
within three to four days. During that interval, Swapco must notify its counterparties as
to a valuation date and carry out the valuation process.
The change in Swapco's exposure to SBHC over the termination period could be de-
termined in one of two ways. One approach would be to take a static book and simu-
late changes in its value over a period of several days by considering alternative paths
for interest rates, exchange rates, and stock prices. The range of outcomes, depend-
ing on the different paths, would suggest potential changes in net exposure. Another
approach, which was taken in this case, is to examine the behavior of a sample book
over a period of time. Specifically, the performance of the Salomon Brothers Inc deriv-
atives book over an 18-month period ending in October 1992 was tracked. The book
consisted mostly of interest-rate and currency-related products, but also included a
small volume of equity-related transactions. That period was relatively volatile in at
least two respects: it included both the disruption of the European Monetary System
during September 1992 and the extraordinary volatility of the Japanese equity market
during August/September 1992.
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