As creditors, counterparties have a clear economic incentive to monitor and perhaps impose limits on hedge funds’ risk-taking, as well as an incentive to protect themselves from large losses should one or more of their hedge-fund customers fail. Counterparties seek to protect themselves against large losses through risk management and risk mitigation.
Risk management includes the use of stress tests to estimate potential exposure under adverse market conditions; riskmitigation techniques include collateral agreements under which hedge funds must daily mark to market and fully collateralize their current exposures.