Book 2. Credit Risk
FRM Part 2
CR 17. Margin (Collateral) and Settlement

Presented by: Sudhanshu
Module 1. Collateral
Module 2. Collateral Agreements
Module 1. Collateral
Topic 1. Introduction to Collateral Management
Topic 2. Valuation Agents
Topic 3. Collateral Agreements
Topic 4. Types of Collateral
Topic 5. Collateral Coverage, Disputes, and Resolutions
Topic 1. Introduction to Collateral Management
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Collateral Management
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Rationale: Mitigate counterparty credit risk and manage credit exposures in trades like OTC forwards and swaps. It's often a bilateral process where either party may be required to post or return collateral.
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Key Goal: The party with a negative mark-to-market (MtM) exposure posts collateral (cash or securities) to the party with a positive MtM exposure. In essence, collateral is an asset that supports a risk in a legally enforceable way.
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Benefits:
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Reduces credit exposure to enable more trading.
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Allows trading with counterparties with credit rating restrictions, as it enables trading on a collateralized basis.
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Reduces capital requirements.
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Allows for more competitive pricing of counterparty risk.
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Evolution: Collateral management has evolved to be highly standardized through the introduction of ISDA documentation in 1994, which includes the Credit Support Annex (CSA).
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Practice Questions: Q1
Q1. Which of the following features is least likely a benefit of collateralization?
A. Reduces capital requirements.
B. Allows for more competitive pricing of counterparty risk.
C. Reduces market, operational, and liquidity risk.
D. Reduces credit exposure.
Practice Questions: Q1 Answer
Explanation: C is correct.
Collateralizing trades reduces credit exposure (credit risk) and capital
requirements, and allows for more competitive pricing of counterparty risk. However, collateralization also creates other risks including market risk (negative equity leaving exposures partially or fully uncollateralized), operational risk (legal obstacles to take possession of collateral), and liquidity risk (difficulty in selling collateral at a fair market value).
Topic 2. Valuation Agents
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Role of a Valuation Agent
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The valuation agent is a key party responsible for managing the daily collateral process. This includes all calculations and initiating collateral deliveries.
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They perform the critical function of calculating credit exposure, market values of the portfolio and collateral, and the net credit support amount, which determines the value of the required collateral delivery or return.
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Key Responsibilities and Scenarios
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Calculations: The agent's core function is to calculate:
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Credit exposure
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Market values of the portfolio
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Credit support amounts
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The precise collateral amount to be delivered or returned.
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Common Scenarios:
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Bilateral: In many cases, both counterparties are capable of acting as the valuation agent, which can sometimes lead to disputes over valuation.
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Third-Party Agent: To avoid disputes and delays, a neutral third-party can be appointed to handle the entire process. This agent produces daily reports and can serve as a trusted, impartial arbiter in case of disagreements.
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Unilateral: Often, a larger entity with more resources will take on the role of the valuation agent for the agreement.
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Topic 3. Collateral Agreements
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Collateral Agreements
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Legal documents that specify the terms and conditions for collateralization.
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Purpose: These agreements serve as the legal framework for the entire collateralization process. They are crucial for ensuring that the collateral provides a legally enforceable mitigation of credit risk.
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Key elements include:
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Currency and Type: The currency in which collateral will be posted and the type of agreement (one-way or two-way).
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Eligible Collateral: The specific types of assets that can be used as collateral.
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Timing: The frequency of margin calls (e.g., daily) and the timing for the delivery of collateral.
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Interest: The interest rates to be paid on cash collateral.
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Types of Collateral
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Cash: Cash is the most common and preferred type of collateral due to its liquidity and price certainty.
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Securities: Other eligible collateral types include:
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Government and government agency securities
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Mortgage-backed securities
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Corporate bonds
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Commercial paper
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Letters of credit
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Equity
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Risks with Non-Cash Collateral:
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Rehypothecation: The practice of a collateral receiver re-using the collateral to satisfy its own funding needs.
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Price Uncertainty: The value of the collateral can change, which is why haircuts are often applied.
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Default Risk: The risk that the security posted as collateral defaults, lowering its value.
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Topic 4. Types of Collateral
Topic 5. Collateral Coverage, Disputes and Resolutions
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Collateral Coverage: It is generally preferred to include the maximum number of trades in collateral agreements to mitigate risk, as this reduces overall exposure.
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Complications: A single trade that cannot be properly valued can lead to disputes and cause delays in the collateralization process.
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It may be optimal to exclude problematic assets (e.g., exotic options, illiquid assets) from the collateral agreement to avoid disputes entirely.
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Dispute Resolution Process: Disputes typically arise from differences in the mark-to-market valuations of the collateral or the portfolio of trades.
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The dispute resolution process is a formalized procedure to handle disagreements and ensure collateral is posted in a timely manner. The steps are as follows:
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Notification: The disputing party officially notifies the counterparty of their intent to dispute a collateral call.
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Immediate Transfer: All undisputed amounts from the collateral call are transferred immediately to avoid further delay.
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Identification of Cause: Both parties must work to identify the specific reason for the dispute, which is often a difference in the valuation of a specific trade.
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Resolution: If the dispute is not resolved through direct negotiation, parties may seek external assistance. A common practice is to obtain quotes from independent market makers to determine the fair market value of the disputed asset or trade.
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- Prevention: Regular, periodic reconciliations of portfolios—even if no collateral is due—can help preempt future disputes by identifying and resolving valuation differences early.
Topic 5. Collateral Coverage, Disputes and Resolutions
Practice Questions: Q2
Q2. Which of the following statements is least accurate regarding a credit support annex (CSA) and/or an ISDA Master Agreement?
A. ISDA Master Agreements help standardize collateral management.
B. CSAs must define all collateralization parameters in order to work as intended.
C. Compared to the ISDA Master Agreement, CSAs were first to establish collateral standards.
D. CSAs are incorporated into an ISDA Master Agreement.
Practice Questions: Q2 Answer
Explanation: C is correct.
The purpose of a credit support annex (CSA) incorporated into an ISDA Master Agreement is to allow the parties to the agreement to mitigate credit risk through the posting of collateral. A CSA is created to govern issues such as collateral eligibility, interest rate payments, timing and mechanics associated with transfers, posted collateral calculations, haircuts to collateral securities (if applicable), substitutions of collateral, timing and methods for valuation, reuse of collateral, handling disputes, and collateral changes that may be triggered by various events.
In order to work as they are intended to work, CSAs must define all collateralization parameters and account for any scenarios that may impact both the counterparties and the collateral they are posting.
Module 2. Collateral Agreements
Topic 1. Collateral Agreement Features (CSA)
Topic 2. CSA Agreements (One-way vs. Two-way)
Topic 3. CSA Calculations
Topic 4. Collateral Agreement Risks
Topic 5. Regulatory Requirements
Topic 1. Collateral Agreement Features (CSA)
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Credit Support Annex (CSA)
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A legal document incorporated into an ISDA Master Agreement, which governs the legal relationship between two parties in privately negotiated derivatives transactions.
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Purpose: The CSA provides the contractual framework for the posting and returning of collateral to mitigate counterparty credit risk. It formalizes the collateral process, ensuring that the collateral is legally sound and enforceable in a close-out netting scenario.
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Parameters defined in a CSA: The CSA is a highly detailed document that defines specific terms for the collateralization process. These parameters include:
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Threshold: This is the uncollateralized exposure amount that a counterparty is willing to accept. Collateral is only posted for any amount of exposure above this threshold. The size of the threshold is often based on the counterparty's credit rating.
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Initial Margin (IM): This is an extra amount of collateral required upfront, independent of the current market exposure (MtM). It is meant to protect against potential future exposure changes during the "margin period of risk" (the time between a counterparty's default and the liquidation of the trades).
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Minimum Transfer Amount (MTA): This is the smallest amount of collateral that can be called in a single margin call. It is designed to reduce the operational burden and costs associated with frequent, small transfers.
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Rounding: The CSA specifies how the final collateral amount should be rounded (e.g., to the nearest $1 million or $100,000). This further reduces the operational complexity of a collateral call.
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Haircut: A discount applied to the value of non-cash collateral to account for its potential price volatility. For example, a haircut of 5% on a bond means that a $100 bond is only valued at $95 for collateral purposes. Haircuts vary based on the type of security and its credit quality.
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Credit Support Amount: This is the net amount of collateral that a counterparty is required to post or return at any given time. It is calculated based on the portfolio's MtM, the threshold, and any initial margin requirements.
Topic 1. Collateral Agreement Features (CSA)
Topic 2. CSA Agreements (One-way vs. Two-way)
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Two-way CSA: In a two-way CSA, both counterparties are required to post or return collateral based on the direction of the market-to-market (MtM) exposure.
- This is the most common type of agreement and is typically used between large, sophisticated financial institutions of similar credit standing.
- Each counterparty has a threshold and minimum transfer amount, though these can be different for each party.
- This symmetry ensures that both parties are protected from credit risk.
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One-way CSA: In a one-way CSA, only one counterparty is required to post collateral.
- This is often seen when one party is significantly more creditworthy than the other (e.g., a major bank dealing with a smaller hedge fund or corporate client).
- The more creditworthy party is the "collateral taker," and the other party is the "collateral provider."
- This type of agreement provides a significant benefit to the collateral taker by reducing their exposure, while placing the entire burden of collateral management on the other party.
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Linking to Credit Quality: The specific terms of a CSA, such as the threshold and minimum transfer amount, are often directly linked to a counterparty's credit rating.
- A decline in a counterparty's credit rating can automatically trigger more stringent collateral requirements, such as a lower threshold.
- This can be problematic, as a ratings downgrade can force a company to post more collateral at a time when its funding is already strained, potentially leading to a "death spiral" where it is unable to meet its obligations.
- For this reason, some agreements may prefer to link collateral terms to other indicators of credit quality, such as credit spreads or the market value of a firm's equity, which are more dynamic.
Topic 2. CSA Agreements (One-way vs. Two-way)
Practice Questions: Q1
Q1. Collateral agreements could potentially create multiple risks, including liquidity and liquidation risks. Which of the following is most accurate regarding liquidity and liquidation risk?
A. Liquidation risk occurs when the amount of a security sold is large relative to its outstanding volume, which may affect the price of that security.
B. Liquidity risk must be hedged in spot and forward markets.
C. Liquidation risk embodies a transaction cost when collateral is liquidated in accordance with initial margin.
D. Liquidity risk occurs when there are potential pitfalls in the handling of collateral, including human error.
Practice Questions: Q1 Answer
Explanation: A is correct.
Liquidating a security in an amount that is large relative to its typical trading volume may negatively impact its price, leading to a substantial loss.
Topic 3. CSA Calculations
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Credit Support Amount (Margin)
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The amount of margin that can be called, which is not necessarily equal to the portfolio value due to thresholds and initial margins. The Credit Support Amount (CSA) is a key calculation in a collateral agreement. It represents the net amount of collateral that a counterparty is required to post or can expect to receive. This amount is calculated daily and is the basis for any margin calls.
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The value of the portfolio is determined using mark-to-market (MtM) valuation, which represents the current value of all trades in the portfolio. It is important to note that the CSA is not just the MtM value. It is adjusted for several other parameters.
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Calculation Example (Simplified)
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Credit Support Amount (for a receiving counterparty): This calculation determines how much collateral Counterparty A should receive from Counterparty B.
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Where:
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value = current value of applicable transactions. This is the net MtM value of the entire portfolio between the two counterparties. If the value is positive for Counterparty A, it has a credit exposure to Counterparty B.
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= threshold for counterparty A. This is the amount of credit exposure that Counterparty A is willing to accept from Counterparty B before a collateral call is made. If the value is less than the threshold, no collateral is required.
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= initial margin for counterparty A. This is a pre-determined amount of collateral that is typically posted at the beginning of the agreement and is held to cover potential future exposure.
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Note: Initial margin is often calculated independently and is not netted. This is because it is designed to cover potential future exposure, which is separate from the current mark-to-market exposure. The initial margin acts as a buffer against large, rapid changes in the market value of the portfolio.
Topic 3. CSA Calculations
Topic 4. Collateral Agreement Risks
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Market Risk Definition: The risk of a change in the value of the portfolio due to market movements that occur between the last collateral posting and the next one. This "gap" creates a residual risk because collateral is not adjusted in real-time.
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Margin Period of Risk (MPOR): This is a critical concept representing the time from the last successful exchange of collateral until a counterparty defaults and the positions are closed out. During this period, market movements can cause the exposure to exceed the posted collateral.
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Contributing Factors: The existence of a threshold and minimum transfer amount means that small changes in the portfolio's value will not trigger a collateral call, leaving a portion of the credit exposure uncollateralized.
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Operational Risk Definition: The risk of loss resulting from failed or inadequate processes, people, and systems. In collateral management, this can include errors in valuation, missed margin calls, or failed collateral deliveries.
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Mitigation: Requires robust IT systems to automate and track margin calls, accurate legal agreements to define all processes, and a careful observation of collateral delivery failures. For example, a failure to issue a collateral call or an incorrect valuation calculation can lead to significant uncollateralized exposure.
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Liquidity and Liquidation Risk
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Liquidation Costs: When a counterparty defaults, the collateral receiver must liquidate the posted assets to cover their exposure. This process incurs transaction costs (e.g., bid-ask spread), which reduces the value of the collateral.
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Impact of Large Trades: In the event of a large default, liquidating a significant amount of collateral in a short time can depress the market price of the asset, further increasing the loss.
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Wrong-way Risk: This is a particularly dangerous form of risk where the counterparty's credit quality and the value of the collateral are linked. The value of the collateral decreases at the same time the counterparty's credit quality deteriorates, exacerbating the loss. For example, if a company's own stock is used as collateral and the company is facing a downturn.
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Funding Liquidity Risk Definition: The risk that an institution will not be able to meet its short-term cash obligations, particularly during a period of stress.
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Collateral Impact: Frequent and large collateral calls can strain a firm's liquidity. If a counterparty has a large negative MtM exposure in a volatile market, it may face multiple margin calls in a short period, potentially exhausting its cash reserves.
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Illiquid Markets: This risk increases during periods of illiquid markets when funding costs can rise considerably, making it more expensive or even impossible to secure the cash needed to meet a collateral call.
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Topic 4. Collateral Agreement Risks
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Other Risks
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Default Risk: The risk that a security posted as collateral defaults, causing its value to drop significantly. Cash or high-quality fixed-income securities are preferred to mitigate this risk.
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Foreign Exchange Risk: Occurs when collateral is posted in a different currency than the underlying trade. Fluctuations in exchange rates can alter the value of the collateral. This risk can be hedged, but it must be managed carefully due to the dynamic nature of currency values.
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Topic 4. Collateral Agreement Risks
Practice Questions: Q2
Q2. When dealing with a hedge fund, a bank would most likely negotiate a:
A. one-way agreement in the bank’s favor given the bank’s stronger credit rating.
B. one-way agreement in the bank’s favor agreeing to post collateral to the hedge fund.
C. two-way agreement given the relatively small difference in credit quality between the two entities.
D. two-way agreement where both parties agree to post collateral.
Practice Questions: Q2 Answer
Explanation: A is correct.
The bank would most likely negotiate a one-way agreement in its own favor given the higher credit quality of the bank. This type of negotiation is typical when there are large differences in credit quality between two entities.
Topic 5. Regulatory Requirements
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Regulatory Requirements
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The global regulatory landscape for OTC derivatives has evolved significantly since the 2008 financial crisis, with a focus on increasing transparency and reducing systemic risk. A key outcome of this has been the move toward central clearing and higher capital requirements for bilateral, non-clearable OTC transactions.
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Non-clearable OTC transactions require banks to hold higher capital requirements compared to standardized OTC transactions. This is to discourage riskier, non-standardized trades and to incentivize the use of central clearinghouses.
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The G20 established a framework in 2011 to address regulatory capital requirements for OTC derivatives. This framework included mandatory clearing of standardized derivatives through central counterparties (CCPs) and bilateral margining requirements for non-centrally cleared derivatives. The goal was to reduce counterparty credit risk and to make the system more resilient to future financial shocks.
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Practice Questions: Q3
Q3. Assume a sovereign bond has a haircut of 5% and is used for a collateral call of $100,000. What amount is credited if a $100,000 bond is submitted, and what amount of bond is needed for $100,000 to be credited, respectively?
A. $100,000; $106,263.
B. $95,000; $100,000.
C. $95,000; $105,263.
D. $105,263; $95,000.
Practice Questions: Q3 Answer
Explanation: C is correct.
A haircut is essentially a discount to the value of posted collateral. In other words, a haircut of x% means that for every unit of collateral posted, only (1−x)% of credit will be given. This credit is also referred to as valuation percentage. If a particular sovereign bond has a haircut of 5% and a collateral call of $100,000 is made, only 95% of the collateral’s value is credited for collateral purposes. That is, in order to satisfy a $100,000 collateral call, $105,263 (= $100,000/0.95) of the sovereign bond must be posted.
CR 17. Margin (Collateral) and Settlement
By Prateek Yadav
CR 17. Margin (Collateral) and Settlement
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