by Dmitry Pugachevsky, Quantifi
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 whitepaper will step through an example where choosing a counterparty with lower current exposure can result in greater counterparty risk.