LO 26.4: Describe the mechanics o f collateral and the types o f collateral that are

LO 26.4: Describe the mechanics o f collateral and the types o f collateral that are typically used.
The process of collateralization is typically done through legal documents under which parties negotiate collateral supporting documents that state the terms and conditions of the process. Collateral agreements should quantify parameters and specify the currency, type of agreement (one-way or two-way), what collateral is eligible, timing regarding delivery and margin call frequency, and interest rates for cash collateral. Trades between counterparties are then marked-to-market (MtM) on an ongoing basis (typically daily), and valuations including netting are determined. The party with the negative MtM exposure then delivers collateral to the other side of the transaction, and the collateral position is updated.
There are many types of collateral used, depending on the riskiness of the credit exposures. Collateral can include cash, government and government agency securities, mortgage- backed securities, corporate bonds and commercial paper, letters of credit, and equity. The most common type of collateral is cash; however, during extreme market events, the supply of cash collateral can be limited. Other collateral types, including agency securities, are often preferred for liquidity; however, recent market events have led to questioning the true riskiness of these securities. In addition, noncash collateral may give rise to problems with rehypothecation (defined later) and create price uncertainty.
C o l l a t e r a l C o v e r a g e , D i s p u t e s , a n d R e s o l u t i o n s

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