Hedging in proportion to the counterparty’s probability of default allows the bank to mitigate potential losses by offsetting the exposure in a measured way, reducing financial risk if the counterparty defaults. This proactive strategy aligns hedge amounts with risk levels, offering a balanced and cost-effective approach to managing credit risk.

A is Incorrect: Monitoring credit ratings alone does not directly protect against financial damage; it only provides information about the counterparty's creditworthiness. B is Incorrect: Requiring large collateral can offer protection but may not be feasible with every counterparty and can strain business relationships. C is Incorrect: Litigation is often costly and time-consuming, potentially worsening losses instead of minimizing them.