Heading Counterparty Risk
“Take calculated risks. That is quite different from being rash.”
George S. Patton (1885–1945)
This chapter deals with the hedging of counterparty risk, which has become a key activity over recent years. Whilst there are many ways to control counterparty risk, without the ability to hedge an institution may find themselves severely limited in the type and amount of transactions they take and the counterparties they trade with. Furthermore, an institution’s total credit value adjustment (CVA) may exhibit severe volatility and therefore potentially lead to large losses. In Chapters 7 and 8 we have discussed CVA, which defines the differen ce between risk-free and counterparty risky derivative(s). Since CVA is presented as a price for counterparty risk, it is natural to ask what the associated “hedge” is. However, as we shall see, hedging counterparty risk poses many challenges due to the many different market variables involved and the potential linkage between them. Ultimately, the hedging will be far from perfect, the most pragmatic solution being to identify the key components of CVA that can and should be hedged, as well as those that cannot.
From an example in Chapter 7, if the EPE for a trade is 5% and the credit spread of the counterparty is 300 basis points per annum, an approxima te CVA is:
Let us suppose that the trade ...