Managing Credit Riskby Counterparty SelectionINTRODUCTIONIn cases where counterparties, e.g., prime brokers, do Selecting Counterparty A for the next trade seemsnot post collateral and CDS protection is prohibitively intuitive but what does this mean for future exposure?expensive, hedge funds tend to manage credit risk Let’s say the next transaction is a 50MM 10-year payerthrough counterparty selection. This typically entails swap executed at mid-market, resulting in no changechoosing the counterparty with the lowest aggregate to current exposure with either counterparty.current exposure (mark-to-market value) for the nextOTC transaction. The problem with this approach is The future value (exposure) of the swap is dictatedthat it doesn’t take into account the potential level of by the shape of the yield curve and volatility of thecurrent exposure on future dates. This paper will step underlying swap rate1. We can determine the range ofthrough an example where choosing a counterparty possible exposures by simulating interest rate scenarioswith lower current exposure can result in greater and re-valuing the portfolio for each scenario. Thecounterparty risk. scenario that results in the largest value represents the maximum loss if the counterparty were to default. The following chart shows the maximum potential EXAMPLE future exposure to Counterparty A and Counterparty For the purposes of this example, let’s say the B if the new swap were added to their respective hedge fund trades with two counterparties, portfolios. Selecting Counterparty A for the new swap A and B. Let’s also make the following transaction results in lower current exposure but not assumptions about the hedge fund’s portfolios necessarily future exposure. In fact, it is possible that with A and B: the exposure to A could be greater within one month and significantly higher further out. Portfolio with Counterparty A This result may seem obvious - adding a payer swap to • A single 10-year payer swap on a portfolio consisting of a single payer swap increases 50MM notional market risk whereas adding it to a portfolio with a • The current exposure (market-to-market receiver swap provides a natural hedge. However, if value) of the swap is ($790,000) the counterparty’s portfolio contains transactions of various types and maturities, the impact of the new transaction on the future exposure may be unclear, Portfolio with Counterparty B requiring tools to evaluate potential scenarios. • A single 10-year receiver swap on 50MM notional • The current exposure (market-to-market value) of the swap is $7.6MM 1 Or volatilities of the 3-month Libor forward rates that make up the curve.
CONCLUSIONHedge funds that manage credit risk by selecting counterparties with the lowest current exposure are not necessarilyminimizing counterparty risk. Depending on the composition of the portfolio and underlying risk factors, a newtransaction may add substantial exposure to a portfolio even if its current exposure is relatively low. Under BaselII and III, banks are required to estimate future counterparty exposures as part of credit value adjustment (CVA)and regulatory capital calculations. The more sophisticated banks use multi-factor Monte Carlo simulation enginesto perform these calculations. As demonstrated above, a simulation engine can provide hedge fund managersadditional metrics to use in choosing counterparties. These exposure projections are also useful in liquidityprovisioning for collateral.Authored by:David Kelly, Director of Credit Products, Quantifi and Dmitry Pugachevsky, Director of Research, QuantifiABOUT QUANTIFIQuantifi is a leading provider of analytics, trading and risk management software for the Global OTC Markets.Top-tier financial institutions in over 15 countries trust Quantifi to provide integrated pre and post-trade solutionsthat better value, trade and risk manage their exposures, allowing them to respond more effectively to changingmarket conditions.London +44 (0) 20 7397 8788New York +1 (212) 784 6815Sydney +61 (02) 9221 email@example.com | www.quantifisolutions.com