1. Managing Credit Risk
by Counterparty Selection
INTRODUCTION
In cases where counterparties, e.g., prime brokers, do Selecting Counterparty A for the next trade seems
not 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 payer
through counterparty selection. This typically entails swap executed at mid-market, resulting in no change
choosing the counterparty with the lowest aggregate to current exposure with either counterparty.
current exposure (mark-to-market value) for the next
OTC transaction. The problem with this approach is The future value (exposure) of the swap is dictated
that it doesn’t take into account the potential level of by the shape of the yield curve and volatility of the
current exposure on future dates. This paper will step underlying swap rate1. We can determine the range of
through an example where choosing a counterparty possible exposures by simulating interest rate scenarios
with lower current exposure can result in greater and re-valuing the portfolio for each scenario. The
counterparty 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.

2. 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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