A major risk faced by a swap dealer is mismatch risk. This is Group of answer choices A) the probability floating rates and exchange rates will not move together. B) the difficulty in finding a second counterparty with an exact opposite match for a swap that the bank has agreed to take with another counterparty. C) the probability that both counterparties default. D) none of the options
The correct answer and explanation is:
Correct Answer: B) the difficulty in finding a second counterparty with an exact opposite match for a swap that the bank has agreed to take with another counterparty.
Explanation (300 words):
Mismatch risk is a major concern for swap dealers. It arises when a dealer cannot perfectly offset a swap contract with another counterparty. In essence, swap dealers act as intermediaries, matching two parties with opposite needs — for example, one wanting to pay a fixed rate and another wanting to pay a floating rate. However, these deals are rarely perfectly symmetrical in terms of notional amounts, payment dates, maturities, or interest rate terms.
When a bank enters into a swap with one client (e.g., a fixed-for-floating interest rate swap), it typically seeks to hedge that exposure by entering an opposite but equivalent swap with another party. Mismatch risk occurs when the dealer cannot find a perfect offsetting counterparty. This leaves the dealer with unhedged exposure — meaning changes in interest rates or currency values could lead to unexpected profits or, more dangerously, losses.
For example, if the dealer has a swap where it pays floating and receives fixed, but can only find another swap where it pays fixed and receives floating (with slightly different terms), the dealer is exposed to market movements because the cash flows don’t cancel out exactly. This creates basis risk, duration mismatch, or timing mismatches.
Mismatch risk is not the same as credit risk (i.e., the risk of a counterparty defaulting) or market risk (i.e., the risk from adverse market movements), although it can amplify both.
Swap dealers must use sophisticated risk management systems to minimize mismatch risk by maintaining a large portfolio of diversified swaps and constantly seeking offsetting positions in the market.
Thus, Option B is correct: mismatch risk is the difficulty in finding a second counterparty with an exact opposite match for a swap that the bank has agreed to take with another counterparty.