Before starting my journey at OSU, I worked for about four years as a credit risk officer at major banks. The purpose of my role was to manage the banks’ risk involved in trading activity with hedge funds.
Counterparty credit risk
The specific type of risk I monitored is known as counterparty credit risk. I’ll break this down a bit. Banks enter into trades with hedge funds / other banks / financial institutions / etc. and each side of the trade (ex. a bank and a hedge fund) can be considered a “counterparty” to the other. And “credit” in this context can be thought of similarly to your credit score. Good creditworthiness means a firm is more likely to be able to meet their financial obligations. So tying these together, counterparty credit risk is the risk that a counterparty (in the context of trading) won’t be able to pay you what they owe you. And very specifically, I only looked at counterparty credit risk where hedge funds were the counterparty to major banks. I looked at the risk to major banks that hedge funds wouldn’t be able to pay the banks what they’re owed from trading activity.
Trading with hedge funds
I’ll give a specific example of counterparty credit risk in the context of hedge funds. A trade that a bank might enter with a hedge fund would be an equity swap. An equity swap gives a hedge fund a very similar exposure to what it could get by directly buying equity stock in a company with the benefit of paying a much smaller upfront cost to get that exposure. For example, a hedge fund could enter into an equity swap trade with a bank where the “underlying” of the equity swap is Apple. After entering into the equity swap, payments can be made in both directions (i.e. the bank could owe the hedge fund money or the hedge fund could owe the bank) depending on which way the price of Apple stock moves. If the price of Apple stock moves up a dollar, the bank owes the hedge fund a dollar and will pay the hedge fund a dollar in some specified period of time. On the other hand, if the price of Apple stock moves down a dollar, the hedge fund owes the bank a dollar. In this way the equity swap closely mimics the exposure of actually buying Apple stock – if the stock goes up, the hedge gains money and if the stock goes down, the hedge fund loses money.
Interestingly, in this trade there are two distinct risks for the bank. The first is market risk. This is simply the risk that Apple stock goes up and the bank thereby loses money (because it owes money to the hedge fund). There will be market risk for the bank in any given trade it enters into, but market risk can still be managed at a higher level. For example, if the bank is “short” Apple in a trade with a hedge fund (i.e. the bank loses money when the price of Apple goes up) it can enter into a separate trade with some other financial institution where the bank is “long” Apple (i.e. the bank gains money when the price of Apple goes up) and these two trades effectively offset each other assuming they are the same size. In this sense, this is an easy way to neutralize market risk.
The other risk involved here is counterparty credit risk. This is the risk that the trade moves favorably for the bank (i.e. the price of Apple stock moves down) so the hedge fund owes the bank money, but the hedge fund does not pay the bank what it is owed. The hedge fund is legally obligated to pay the bank what it is owed, but there could be situations where the hedge fund is in financial trouble and is unable to pay the bank. There is no generally simple way to neutralize counterparty credit risk particularly in the case of hedge funds. Thus, there is a lot of effort put forth to ensure that the hedge funds that banks trade with are creditworthy (very likely to be able to meet their financial obligations).
Hedge fund creditworthiness
So how would we determine the creditworthiness of a hedge fund? If you’re looking to invest in a hedge fund, you would likely primarily look at the strategy of the hedge fund and how it aligned with your financial needs as well as the historic performance of the hedge fund and the track record of its key managers. While all of these are factors in determining the creditworthiness of a hedge fund, the focus is quite a bit different. From a credit officer’s perspective, the best hedge fund to trade with would be one that is huge (in terms of the amount of money it is managing), has a long track record of extremely stable returns (even if the returns are very meager), and has a highly diversified portfolio.
Bigger is better
Generally speaking, as a credit risk officer it was always better to trade with big hedge funds rather than small hedge funds. This is because for a very large hedge fund, any given trade you enter into with the hedge fund would likely represent a relatively small portion of the hedge fund. Thus a large move relative to the trade would be a small move in the context of the size of the hedge fund and the hedge fund likely wouldn’t have any issue paying what they owe. As an analogy, you would be much more confident that a billionaire could pay their parking ticket than any person taken at random.
Pick the tortoise over the hare
Another positive characteristic of a hedge fund for a credit risk officer is the stability of the returns of the hedge fund (and the longer the track record of these stable returns, the better).
Consider two games you could play. The context – initially I give you $100 (for nothing) and then you pick one game to play as many times as you want (but it has to be the same type of game each time). In Game A, I flip a coin – if it turns up heads I’ll pay you $100 and if it turns up tails you’ll have to pay me $50. In Game B, I flip a coin – if it turns up heads I’ll pay you $1 and if it turns up tails you’ll have to pay me $1. Game A would lead to more volatile returns (each game results in a bigger swing in your available money) and Game B would lead to more stable returns.
A lot of people would prefer to play Game A – and for good reason, the odds are in your favor. But if “you” were a hedge fund and a credit risk officer was considering you as a counterparty, they would much prefer if you played Game B. The biggest fear for a credit risk officer is that your hedge fund won’t be able to pay the bank what it’s owed. How could you be unable to pay the bank? One way would be if your strategy caused you to lose all of your money. In Game A, you’d only have to lose twice in a row (25% chance) to lose your full $100. In Game B, on the other hand, the fastest way to lose all of your money would be if tails was flipped 100 times in a row (~7.9 X 10-29 % chance). The credit risk officer is much more confident you’re not going to lose all of your money playing Game B.
Diversity is safety
Consider two extremes for a hedge fund’s portfolio:
1) The hedge fund’s full portfolio is invested in Google
2) The hedge fund is invested in 100 different large companies (say about 1% of the portfolio in each of the companies), one of which is Google
A credit risk officer will have a problem with hedge fund #1. What happens if tomorrow a new search engine is released that is undeniably far better than Google’s search engine? It “understands” your queries much better and subjectively tends to get people results that much more closely align with what they’re requesting. The search engine starts spreading like wildfire and Google’s traffic is declining dramatically. Google’s stock price would likely be crushed and hedge fund #1 would take a massive hit. This hedge fund may now have a very hard time meeting its financial obligations.
What would happen to hedge fund #2? Even if Google completely evaporated and the stock price declined to $0 (for the sake of argument, of course Google/Alphabet is much more now than just a search engine), hedge fund #2 would only see a 1% dip in performance. By diversifying, the hedge fund’s performance is much less closely tied to any single company’s performance and you can be much more confident that there won’t be wild swings in the performance of the hedge fund.
Credit ratings
I’ve discussed a few key factors that go into assessing the creditworthiness of a hedge fund, but there are many more to consider. These factors are all considered together and as a credit officer you assign a hedge fund a credit rating. This credit rating is very similar to a person’s credit score. A better credit rating means the credit officer thinks the hedge fund is more likely to be able to meet its financial obligations. These credit ratings will help guide the type and amount of trading that the bank will engage in with any given hedge fund (or if the bank will trade with the hedge fund at all).
