Managing Counterparty Risk
The global financial markets operate through a series of interconnected contracts among counterparties in the market, ranging from global commercial and investment banks, to corporate end-users, asset managers, insurance companies and individual investors. The smooth functioning of the global financial markets relies on each of these counterparties fulfilling its contractual obligations. Counterparty risk is the risk that a party to a transaction or contract will fail to fulfill its contractual obligations.
In the context of hedge funds, the most significant counterparty risk arises under contracts between the hedge fund and its most common trading counterparties, specifically investment banks and prime brokerages. The simplest form of counterparty risk facing the typical hedge fund is non-payment or non-performance by a prime broker or investment bank under a swap agreement or other OTC derivatives contract. If the contract is in the money and the counterparty fails to pay at maturity, the hedge fund will incur a loss. If the counterparty defaults before maturity, the hedge fund may have to replace the swap with a more costly one at a new counterparty that may be more costly. In addition, under a typical swap, a hedge fund is required to post collateral at the inception of the swap (this is called initial margin) and then periodically increase or decrease that collateral throughout the life of the swap as the swap value rises and falls (this ...