Chapter 16
Hedging Counterparty Risk
This chapter deals with the hedging of counterparty risk, which has become a key activity over recent years. There are certainly many ways to mitigate counterparty risk. However, 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, due to internal or regulatory capital restrictions (Chapter 17). Furthermore, an institution's total CVA (and DVA) may exhibit severe volatility and potentially lead to large losses. However, as we shall see, hedging CVA poses many challenges due to the 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, or should not.
Trade-level CVAs are relatively small due, primarily, to the relatively low default probability of the counterparty and the exposure-reducing effects such as netting and collateral. A typical CVA will be a fraction of a percentage point of the notional of a trade. However, were the counterparty to default, the actual losses might well be much higher. For example, the four-trade example in Table 13.1 has a CVA of 237,077. However, considering a potential counterparty default at 2 ...
