This paperc onstructsa model for measuring the gains realized by both counterparties to a currency swap that takes place in an international market in which financial arbitrage opportunities exist. Conditions are derived for zero-sum and nonzero-sum outcomes for both default-free swaps and risky swaps in terms of state-contingent interest rate/exchange rate parities.In an imperfect international capital market,swaps with default risk can give rise to greater gains than a default-free swap. Possibility of default, state by state,becomes a screening device for favorable and unfavorable exchange rate out comes for each counterparty.Thus, the possibility of default,perse,is not the sole determinant of the degree of credit risk in a swap agreement.Covariability of exchange rates and default states plays an offsetting role.
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