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.

Request A Copy


Innovative thinking


The Growth of Relative Value Credit Strategies

Although markets are less volatile than they were in the teeth of the COVID-19 gale that blew in March and April 2020, there are still plenty of factors which could introduce new volatility.


How to Manage Cryptoasset Credit Risk

The Global Financial Crisis (GFC) of 2008 underscored the importance of credit risk in the financial markets. Since 2008, regulatory reform has been introduced to restore stability and confidence in the banking industry.


A First View on the New CVA Risk Capital Charge

The impact of the new CVA risk regulation framework on calculation methods and the infrastructure of banks could potentially be the turning point for many of the medium-sized institutes we are seeing in the market.

Let's talk!

Speak with one of our solution experts