Managing Credit Risk by Counterparty Selection
In cases where counterparties, e.g. prime brokers, do not post collateral and CDS protection is prohibitively expensive, hedge funds tend to manage credit risk through counterparty selection.

This typically entails choosing the counterparty with the lowest aggregate current exposure (mark-to-market value) for the next OTC transaction. The problem with this approach is that it doesn’t take into account the potential level of current exposure on future dates.

This paper will step through an example where choosing a counterparty with lower current exposure can result in greater counterparty risk. For the purposes of this example, let’s say the hedge fund trades with two counterparties, A and B. Let’s also make the following assumptions about the hedge fund’s portfolios with A and B:

Portfolio with Counterparty A
• A single 10-year payer swap on 50MM notional
• The current exposure (market-to-market value) of the swap is ($790,000)

Portfolio with Counterparty B
• A single 10-year receiver swap on 50MM notional
• The current exposure (market-to-market value) of the swap is $7.6MM

Hedge funds that manage credit risk by selecting counterparties with the lowest current exposure are not necessarily minimizing counterparty risk. Depending on the composition of the portfolio and underlying risk factors, a new transaction may add substantial exposure to a portfolio even if its current exposure is relatively low.

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