CH13 - Mitigating Derivative Counterparty CR

Question 1

List the 5 basic criteria that collateral assets must meet in order to mitigate credit risk

Answer 1

1. Credit Quality
2. Liquidity
3. Price Stability
4. Correlation
5. Security Interest

Question 2

1. Credit Quality

Answer 2

The collateral received to mitigate counterparty credit risk cannot pose credit risk in its own right. For example, usually only highly rated bonds (AAA, AA) are used as opposed to low-rate bonds which may themselves default.

Question 3

2. Liquidity

Answer 3

• Must be able to sell the collateral easily
• Instruments with deep markets like government bonds are preferred because they can be sol easily
• Highly liquid collateral assets are easy to value, which facilitates the process

Question 4

3. Price Stability

Answer 4

• If collateral’s price is volatile, the price movement between the two valuation dates can cause losses
• A sharp decline of MTM values can trigger a margin call, which is settled the following day and exposes the firm
• Money can also be lost between the time that the decision to sell collateral assets is made and that the proceeds are delivered

Question 5

4. Correlation

Answer 5

• Collateral must not be correlated either with the counterparty or with the underlying product
• If the risk of the counterparty defaulting coincides with the loss of value (or default) or the collateral, the mitigating effects are worthless

Question 6

5. Security Interest

Answer 6

The right to truly own and liquidate the collateral in a default scenario must be conveyed to the party that receives it.
-In case of default, a third party must not claim the rights to the collateral