Recently, a large U.S. companyexecuted a sizable portfolio of cross-currency derivatives to hedgeits international exposure. As it evaluated prospective swapstrading partners, the company—let's call it XYZ Corp.—was surprisedby both the size and the variance in credit-charge markups proposedby the different banks. It was also concerned about the significantcredit risk posed by some of the banks and was unsure how best tomanage this exposure.

When XYZ had executed derivatives trades in the past,counterparty risk was not top-of-mind. Its discussions with bankstypically focused on two topics: market rates and how much markupthe banks would add to the market rates to compensate for XYZ'scredit risk and provide a return on capital. XYZ would typicallycompare the markups among its stable of swaps banks and award eachtrade to the lowest-cost provider.

On the surface, this approach appeared to help XYZ select theprovider with the lowest price, but it had two critical flaws.First, it ignored the providers' relative credit quality; thecompany treated all counterparties as equal. Over the past severalyears, XYZ has begun to pay more attention to the counterpartyrisks posed by its banks, and in deciding which bank to award itscurrent swaps business, the company wanted to take the banks'credit profiles into consideration as it weighed their pricingdifferences. Second, XYZ's former approach to evaluating swapsproviders gave the banks the opportunity to show a competitivecredit markup to win the trade, with the intent of makingadditional profit by showing a less attractive “market rate” thanmight be available elsewhere in the market.