Explanation:
When a financial institution holds multiple contracts with the same counterparty, implementing a netting agreement is widely considered the most effective first step in counterparty credit risk mitigation. A netting framework allows positive and negative exposures from various contracts to be offset against each other, yielding a single net exposure. This significantly reduces the gross exposure facing the counterparty.
"Selling" credit default swaps would mean taking on more credit risk; to hedge, the fund should "buy" them. Netting offers a foundational, structural reduction in counterparty exposure risk spanning across all existing trades.
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Q.7 A hedge fund has the following credit risk exposures to AB&B, an A-rated corporation:
| Contract | Contract value (USD) |
|---|---|
| A | 44,000,000 |
| B | 88,000,000 |
| C | 35,200,000 |
| D | 3,300,000 |
| E | 20,000,000 |
The fund is looking into ways of reducing counterparty credit risk. Which of the following credit risk mitigation techniques would be most appropriate?
A
Implementing a netting framework
B
Increasing collateral
C
Use of credit triggers
D
Sell credit default swaps