Evaluating counterparty risk

A protection buyer can suffer a credit loss on a default swap only if the underlying
obligor and the protection seller simultaneously default, an event whose probability
is technically referred to as their ‘joint probability of default’.
To limit risk, credit-hedging institutions should carefully evaluate the correlation
between the underlying obligor and the protection seller. Hedgers should seek
protection seller counterparties that have the lowest possible default correlation with
the underlying exposure. Low default correlations imply that if one party defaults,
only a small chance exists that the second party would also default. For example, a
bank seeking to hedge against the default of a private sector borrower in an emerging
market ordinarily would not buy protection from a counterparty in that same
emerging market. Since the two companies may have a high default correlation, a
default by one would imply a strong likelihood of default by the other. In practice,
some credit hedging banks often fail to incorporate into the cost of the hedge the
additional risk posed by higher default correlations. The lowest nominal fee offered
by a protection seller may not represent the most effective hedge, given default
correlation concerns. Banks that hedge through counterparties that are highly
correlated with the underlying exposure should do so only with the full knowledge of
the risks involved, and after giving full consideration to valuing the correlation costs.