Selecting Counterparty A for the next trade seems intuitive but what does this mean for future exposure? Let’s say the next transaction is a 50MM 10-year payer swap executed at mid-market, resulting in no change to current exposure with either counterparty.

The future value (exposure) of the swap is dictated by the shape of the yield curve and volatility of the underlying swap rate1. We can determine the range of possible exposures by simulating interest rate scenarios and re-valuing the portfolio for each scenario. The scenario that results in the largest value represents the maximum loss if the counterparty were to default.

The following chart shows the maximum potential future exposure to Counterparty A and Counterparty B if the new swap were added to their respective portfolios. Selecting Counterparty A for the new swap transaction results in lower current exposure but not necessarily future exposure. In fact, it is possible that the exposure to A could be greater within one month and significantly higher further out.

This result may seem obvious - adding a payer swap to a portfolio consisting of a single payer swap increases market risk whereas adding it to a portfolio with a receiver swap provides a natural hedge. However, if the counterparty’s portfolio contains transactions of various types and maturities, the impact of the new transaction on the future exposure may be unclear, requiring tools to evaluate potential scenarios.

1 Or volatilities of the 3-month Libor forward rates that make up the curve.

Managing Credit Risk by Counterparty Selection

EXAMPLE

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

INTRODUCTIONIn 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.

CONCLUSION

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. Under Basel II 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 engines to perform these calculations. As demonstrated above, a simulation engine can provide hedge fund managers additional metrics to use in choosing counterparties. These exposure projections are also useful in liquidity provisioning for collateral.

Authored by: David Kelly, Director of Credit Products, Quantifi and Dmitry Pugachevsky, Director of Research, Quantifi

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