I’m actually working on a little project and for those already in the business (back office, middle office or front office), I was wondering how your team was setting up counterparty exposure limits for a specific fund.
Let’s say that I’ve 4 counterparties (Goldman, BAML, CIBC and BNP Paribas). I’ve a fund invested mostly in Governments bonds. What’s the best way to cap the maximum possible exposure to a specified counterparty ? What’s the best way to get a specific amount as a limit (example: maximum possible exposure for Goldman Sachs for this specific fund should be 1 millions).
Clerarly something that we do not work much in the CFA program.
I haven’t established limits, but conceptually I think the best option is naive 1/n. Since you wouldn’t be comfortable losing $1m from Goldman, why would it be ok to lose more than $1m with another counterparty? I guess you could make an adjustment for credit quality, but I feel like default would be idiosyncratic, or a systemic failure. Either way concentrating in any wouldn’t be the best option.
Just my thinking. Not experience based. Good luck.
Well the 1/n rule did not occur to me but if I remember correctly according to CFAI, it is a surprisingly good strategy for portfolio diversification. Not sure what to think of it as a strategy because I am currently not in AM industry. Nevertheless, I enjoy the topic so I will make a puny try based on my banking experience and CFA knowledge.
The strategy that did occur to me was setting a maximum dollar wise limit I would be willing to lose, say $5M. Then I would try given the data (i.e. volatility of returns, credit spreads, duration and correlation) from counterparties to calculate the probability of my portfolio reaching such losses and compare it to other investments and finally compare risk/return characteristics. Another important thing to keep in mind is the strategy of the fund (is it long only, etc) because some data may be irrelevant.
In short, IMO limits should be based on reasonable expected losses (including some stress testing). If worst case scenario is that you may lose 10% while given the risk/return characteristics you are ok to take risk so that you lose up to 7M then your exposure should not exceed 70M
Counterparty limit determination is not simple as using 1/n rules. You need to relate at least 3 factors such as your company’s equity, borrower’s equity and probability of default.
Suppose PD of 20% then you can use minimun of 5% of your equity or 10% of counterparty’s equity multiply by (1 - PD).
I work in credit and I believe theres not a specific rule to setting up limits, it all depends on your company’s risk appetite and level of business desired. Traders usually request a certain transaction and it’s up to us to determine how much exposure can potentially arise given MTM and changes in AP/AR(think floating index pricing, I’m in the commodities business) so the amount of exposure can get pretty high. That being said, we have a large credit facility backed by our $4B parent company, so it’s common for us to have limits well in the $30-$50MM range for companies like Goldman Sachs. However limits like these are all covered under a CSA with specific ranges depending on public credit ratings. If we were dealing with let’s say a subsidiary of Goldman sachs the parent would need to provide a guaranty to allow us to extend credit, which at that point the credit limit would all depend on the face amount of the guaranty. As always, for non rated entities we do a dive into their financials and try to find reason to extend the amount of credit needed to satisfy the trader’s request. If there’s no required amount the easiest way to extend unsecured credit at a conservative level would be 3% of equity(obviously for a billionaire company that would be huge as $30MM is quite an excessive amount of unsecured credit). At the end of the day it depends on your company’s ERM system.
I think those should already be established rules for counterparty risk. Coming up with new rules seems like ad-hoc solutions. But if in a squeeze, I’d go with the counterparty’s credit rating and reputation, because you don’t have much more to go on with.
I work quite a bit with collateral and cpty risk but the limits are not something that I (MO) calculate/decide ourselves. It’s based on how much leeway risk department and FO is willing to give and how it fits the overall strategy.
I don’t believe you want to distinguish by cpty especially when it comes to limits. You want limits/constraints to be a % of an asset figure and a % of your equity figure. This is especially set at policy level allowing tactical adjustments based on desk’s experience with individual counterpartys.
for example you want to do more business with a certain cpty, you could approach but not exceed the limit.
revisit the policy if the desk feels its hands are tied if the translated $ constraint is unreasonable.