Counter party risk &: building new hedging strategies: initially of greatest concern to the banking sector, counterparty risk has taken on a decidedly more global role as focus shifts to sovereign sector - collapsing economies in Europe and other volatile markets.

• Author: Bullock, Steve
• Position: Treasury

Counterparty risk management has enjoyed increased priority in the field of corporate treasury management ever since the global financial crisis struck three years ago. The initial shock focused on the banking sector, with concerns about counterparty viability and the related drying up of credit and liquidity

Today, the focus has shifted to the sovereign sector, most notably in response to the Euro Zone's trend of rising interest rates against the backdrop of supporting arduous restructuring and refinancing programs for its smaller and weaker members, such as Portugal.

One of the most vital roles of a corporate treasury department is the protection of the value of the organization's assets, earnings and profits. These are manifestly at risk if the creditworthiness of several counterparties declines, especially if this occurs suddenly and rapidly, rendering the exposure matrix even more difficult to measure and manage.

Recent history shows that such violent changes can occur with individual institutions, classes of institutions, countries, geographic regions and economic/financial zones such as the European Union.

Accordingly, corporate treasurers continue to research and implement improved methodologies and strategies to manage counterparty risk, and to define and execute optimal hedging strategies to mitigate this risk, in market conditions that are frequently volatile and unpredictable.

Here are some of the key issues that corporate treasurers need to analyze and manage as they strive for the best-practice resolution of a dynamic, complex and all too real manifestation of risk.

Treasury manages the following forms of counterparty risk:

* Investment risk--related to the value of investments, including cash balances and deposits;

* Liquidity risk--the drying up of essential sources of funds;

* Hedging risk--the effect of creditworthiness on the effectiveness and viability of hedges (an important issue that is often overlooked); and

* Settlement risk.

Investment Risk. The creditworthiness of the issuers of equities and bonds and money market instruments held in financial investment portfolios is an obvious starting point for measuring counterparty risk. Perhaps less obvious is the risk inherent in bank account deposits.

Collateral held against assets falls into this general risk category. All these elements need to be taken into consideration when allocating, managing and reviewing counterparty limits for investment purposes--a most...