That is why we must include the potential favourable change in value of the swap. A swap with zero value at inception does not have zero credit risk. It has credit risk from its potential value in the future. Credit enhancement and derivatives Because credit risk is such a tremendous overhang in any relationship, banks and dealers have worked with lawyers to develop techniques that help mitigate the credit exposure inherent in derivatives transactions. First among these techniques is the concept of netting.
Netting takes different forms, depending upon the institutions involved.
Imagine DEF Bank and Flying Boats Incorporated. They have a number of outstanding interest rate swap contracts on the books, some of which involve cash flows on the same day. DEF and Flying Boats have a netting agreement in place that compels them to net the cash flows on any given delivery date into its root payment. Second , DEF may ask Flying Boats to put up some collateral against the market value of the swap. This is the same kind of concept as the margining that is used on the futures exchanges.