Mitigating Counterparty Risk

Abstract

This paper provides initial evidence on counterparty risk-mitigation activities of financial institutions on the basis of Depository Trust and Clearing Corporation’s (DTCC) proprietary bilateral credit default swap transactions and positions. We investigate whether financial institutions that are active buyers of protection from a specific counterparty undertake successive contracts and purchase protection written on them, while avoiding wrong-way risk mitigation. The trading intensive dealer banks are more active in hedging both over short and longer horizons, whereas non-dealer banks manage this risk only over longer, monthly intervals. Higher stock return and CDS price volatility, lower past stock returns, and higher CDS prices of the counterparty are shown to have an increasing effect on the hedging behaviour against the counterparty. In addition to its usage for ongoing CVA risk-mitigation activities, purchasing protection on counterparties is shown to be a viable instrument beyond receiving coverage through collateral.