The following excerpt is taken from an article titled "IRS Rule to Open Swaps to Pension Funds," which appeared in the November 18, 1991, issue of BondWeek, pp. 1-2: A proposed Internal Revenue Service rule that gives tax-free status to income earned on swaps by pension funds and other tax-exempt institutions is expected to spur pension fund use of these products, say swap and pension fund professionals... UBS Asset Management has received permiss on from most of its pension fund clients to use interest rate and currency swaps in its fixed- income portfolios and is awaiting the IRS regulation before stepping into the market, says Kenneth Choie, v.p. and head of research and product development...."The IRS' proposed rule is great news for pension fund managers," as the use of swaps can enhance returns and lower transaction costs, Choie says....

While some pension funds are exploring the swap market, pension fund consultants underscore that the funds' entrance into the market is likely to be slow. Counterparty risk has been a more formidable obstacle than the ambiguity of the tax status of income from interest-rate and currency swaps, says Paul Burik, director of research at Ennis, Knupp & Associates, a pension fund consulting firm. [Note that the rule referred to above has been adopted.]

a. In the article, Choie indicates that one "possible application that UBS is consider- ing is to switch between fixed- and floating- rate income streams without incurring the transaction costs of trading chunks of securities" Explain how an interest-rate swap can be used for this application.

b. What is counterparty risk?

c. How can counterparty risk be reduced?AppendixLO1