Mitigating counterparty risk in derivatives trades
Recently, a large U.S. company executed a sizable portfolio of cross-currency derivatives to hedge its international exposure. As it evaluated prospective swaps trading partners, the company—let's call it XYZ Corp.—was surprised by both the size and the variance in credit-charge markups proposed by the different banks. It was also concerned about the significant credit risk posed by some of the banks and was unsure how best to manage this exposure.
When XYZ had executed derivatives trades in the past, counterparty risk was not top-of-mind. Its discussions with banks typically focused on two topics: market rates and how much markup the banks would add to the market rates to compensate for XYZ's credit risk and provide a return on capital. XYZ would typically compare the markups among its stable of swaps banks and award each trade to the lowest-cost provider.
On the surface, this approach appeared to help XYZ select the provider with the lowest price, but it had two critical flaws.....
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