Other Risks

This section is small, not because these risks are unimportant, but because it is difficult to integrate them into a comprehensive measure of risk that we can allocate to. Counterparty risk, for example, is contractual exposure to other agents, for example, uncollateralized derivatives exposure with custodians and investment banks or managers. This risk is captured through a credit default swap (CDS), which is the interest rate spread we pay to insure our positions. If the CDS spread is rising, then that means that the market is pricing in more risk of default. As an example, suppose our portfolio has a position with a counterparty that is currently earning us 5 percent. We want to insure against our counterparty defaulting and so look to buy a CDS. Suppose the spread is currently 300 bps. If we were to buy the CDS, then our net return would fall to 2 percent. As the risk rises, so does the spread, which draws our return down further.

The notional market for credit default swaps was estimated to be around $50 trillion in 2008, and a lot of that was in short positions, that is, insurers like AIG wrote or sold these, meaning that AIG was on the hook to pay up in the case of default. That's another story but the point is that the market for CDS has expanded to include counterparties of all types, including sovereign and state governments.