Explanation:
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.
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Q.1998 A bank enters into multiple derivative contracts with multiple counterparties. Which of the following best explains how the bank can prepare for default so as to ensure any actual default event inflicts minimum financial damage?
A
Through continuous monitoring of the credit rating of each counterparty.
B
By demanding to post huge amounts of collateral before the commencement of the contract.
C
Initiating litigation immediately after a counterparty shows signs of default.
D
By gradually taking hedged positions in proportion to the counterparty’s probability of default.
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