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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.
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




ABOUT QUANTIFI
Quantifi 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 solutions
that better value, trade and risk manage their exposures, allowing them to respond more effectively to changing
market conditions.

London      +44 (0) 20 7397 8788
New York    +1 (212) 784 6815
Sydney      +61 (02) 9221 0133

enquire@quantifisolutions.com | www.quantifisolutions.com

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Managing Credit Risk by Counterparty Selection

  • 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 ABOUT QUANTIFI Quantifi 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 solutions that better value, trade and risk manage their exposures, allowing them to respond more effectively to changing market conditions. London +44 (0) 20 7397 8788 New York +1 (212) 784 6815 Sydney +61 (02) 9221 0133 enquire@quantifisolutions.com | www.quantifisolutions.com