Last year, J.P. Morgan & Co. reported entering into interest rate swaps with a "notional value" of more than $367 billion. But the bank reported credit exposure on the swaps --and on another $85 billion related to foreign currency swaps -- of just $8.3 billion.

Did the international banking giant really put at risk only $8.3 billion on a notional value of almost 50 times as much? And just what is the notional value of a swap, and is it a useful measure of exposure?

An interest rate swap is simply an agreement by two parties to exchange a flow of interest payments for a set amount of time. Frequently, one party agrees to pay interest at a fixed rate while the other party will pay interest at a floating rate, such as the London Interbank Offered Rate.

Underlying the exchange of interest payments is a loan that is not exchanged. The notional value of a swap refers to the amount of the loan to which the swap is tied.

For example, if a city sells $100 million of variable-rate bonds, it may decide to lock in a fixed rate on the bonds with a swap.

A counterparty, usually a large bank or underwriting firm, agrees to pay the variable rate due on the bonds, in effect a small percentage of the $100 million bond issue. In return, the city agrees to pay the counterparty a fixed rate, say 5.50% of the $100 million each year.

The notional amount of the swap, in this case, would be $100 million.

But the swap transaction does not put the city or the counterparty at risk of losing $100 million. Even if the city or the counterparty were to default on their swap payments, the maximum loss would be the maximum interest on the bonds.

If the counterparty defaulted, the city would have to pay the actual floating rate on the bonds instead of paying a fixed rate of 5.50%. That could be 5% or 10% more than the city had been paying, or about $5 million to $10 million. The city could also end up paying less if the floating rate on the bonds were to drop below 5.50%.

The notional value of an interest rate swap reveals little about the amount each side actually has at risk

"People pay much to much attention to those numbers," said Merton Miller, the Nobel Prize-winning professor of economics at the University of Chicago "It grossly exaggerates the amount of money involved."

The market instead relies on a more precise measure of possible loss on a swap -- replacement value.

If a swap counterparty defaults, the city could call a few swap dealers and get bids for a replacement swap similar to the original. The cost for this would also be much less than the national value of the swap.

At the end of 1992, for example, Merrill Lynch reported it had entered into swaps with a notional value of $457 billion, but a replacement value of $4.3 billion.

Then again, replacement value may not be such a perfect measure either, according to Professor Miller.

"There really is no simple measure. The only way to truly evaluate the risk is to look at the whole thing, the entire collection, like evaluating a portfolio," Miller said.

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