Articles by kenli

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

LO 26.3: Describe the role o f a valuation agent.
The valuation agent is responsible for calling for the delivery of collateral and handles all calculations. The valuation agents role is to calculate (1) credit exposure, (2) market values, (3) credit support amounts, and (4) the delivery or return of collateral. Larger entities often insist on being valuation agents when dealing with smaller counterparties. When the size difference between counterparties is small, both counterparties may be valuation agents. In this case, each entity would call for collateral when they have positive exposure; however, this could lead to disputes and delays in processing collateral movements. One remedy is to use a third-party valuation agent that would handle the collateral process, processing collateral substitutions, resolving disputes, and producing daily valuation reports.
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C o l l a t e r a l A g r e e m e n t s a n d T y p e s o f C o l l a t e r a l

LO 26.2: Describe the terms o f a collateral agreement and features o f a credit support annex (CSA) within the ISD A M aster Agreement including threshold, initial margin, m inim um transfer am ount and rounding, haircuts, credit quality, and credit support amount.
The concept behind collateralization is straightforward. When two parties execute certain trades (e.g., OTC forwards, swaps), one will have a negative MtM (mark-to-market) exposure, and the other party will have a positive MtM exposure at any given time. The party with the negative exposure will then post collateral in the form of cash or securities to the party with the positive exposure. In essence, collateral is an asset supporting a risk in a legally enforceable way. Collateral management is often bilateral, where either side to a transaction is required to post or return collateral to the side with the positive exposure.
Firms can manage credit exposures and mitigate counterparty credit risk by either limiting the notional value of trades with counterparties or offsetting trades that limit exposure though netting. There are essentially four motivations for managing collateral: (1) reduce credit exposure to enable more trading, (2) have the ability to trade with a counterparty (e.g., restrictions on credit ratings may preclude an entity from trading on an uncollateralized basis), (3) reduce capital requirements, and (4) allow for more competitive pricing of counterparty risk.
Collateral management has evolved over the last few decades from having no legal standards to being highly standardized through the introduction of ISDA documentation in 1994. 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. Because collateral can vary greatly in terms of amount, liquidity, and risk levels (as well as many other elements), a CSA is created to govern issues such as
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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 intended, CSAs must define all collateralization parameters and account for any scenarios that may impact both the counterparties and the collateral they are posting.
Parameters established with CSAs (and collateralized agreements in general) include the following:
Threshold: Collateral will be posted when the level of MtM exposure exceeds this

threshold level. Initial margin (also known as independent amount in bilateral markets): The amount of extra collateral that is required independent of the level of exposure.
Minimum transfer amount: The minimum amount of collateral that can be called at a
given time.
Rounding: Collateral calls or collateral returns may be rounded to specific sizes to avoid
working with inconvenient quantities.
Haircut: This reduces the value of collateral to account for the possibility that its price
may fall between the previous collateral call and a counterparty default.
Credit quality: As counterparty credit quality declines, the importance of collateral
increases.
Credit support amount: The amount of collateral that may be called (by either
counterparty) at a certain point in time.
Professors Note: The terms o f a collateral agreement as well as descriptions of threshold, initial margin, minimum transfer amount, rounding, haircuts, and credit quality will be addressed in LO 2 6 .6 when we explain the features o f a collateralization agreement.
V a l u a t i o n A g e n t s

LO 26.1: Describe the rationale for collateral management.

LO 25.5: Identify and describe termination events and discuss their potential effects on parties to a transaction.
Termination events allow institutions to terminate a trade before their counterparties become bankrupt. A reset agreement readjusts parameters for trades that are heavily in the money by resetting the trade to be at the money. Reset dates are typically linked with payment dates, but they could also be triggered after a certain market value is breached. As an example, consider a resettable cross-currency swap. With this trade, the MtM value of the swap is exchanged at each reset date. In addition, the foreign exchange rate, which influences the swaps MtM value, is reset to the current spot rate. This reset will end up changing the notional amount for one leg of the swap.
Additional termination events (ATEs), which are sometimes referred to as break clauses, are another form of a termination event, which allow an institution to terminate a trade if the creditworthiness of their counterparty declines to the point of bankruptcy. More specifically,
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a break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Break clauses are often bilateral, allowing either party to terminate a transaction, and are useful in providing an option to terminate transactions particularly long-dated tradeswithout cost when the quality of the counterparty declines. Events to trigger a break clause generally fall into three categories:
Mandatory. The transaction will terminate at the date of the break clause. Optional. One or both counterparties have the option to terminate the transaction at the
pre-specified date.
Trigger-based. A trigger, like a ratings downgrade, must occur before the break clause
may be exercised.
Despite their advantages, break clauses have not been highly popular. One explanation is that break clauses, in effect, represent a discrete form of collateralization; however, collateralization can be better achieved by the continuous posting of collateral. .Another explanation is known as bankers paradox, which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterpartys credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.
Walkaway clauses allow an entity to benefit from the default of a counterparty. Specifically, under these clauses an entity can walk away from, or avoid, its net liabilities to a counterparty that is in default, while still being able to claim in the event of a positive MtM exposure. Walkaway clauses were popular prior to 1992, but they have been less common since the 1992 ISDA Master Agreement. They have also been criticized for creating additional costs for a counterparty in the event of a default, for creating moral hazard, and, because a walkaway feature may already be priced in a transaction, hiding some of the risks in a transaction. For these reasons, these clauses should be ultimately avoided.
As mentioned previously, multilateral netting is achieved with a central entity, such as an exchange or clearinghouse, handling the netting process, including valuation, settlement, and collateralization. An approach for utilizing multilateral netting without the need for a membership organization is trade compression. Because portfolios often have redundancies among trades with multiple counterparties, compression aims to reduce the gross notional amount and the number of trades (e.g., OTC derivatives transactions). Thus, trade compression can reduce net exposure without the need to change an institutions overall risk profile.
Trade compression requires participants to submit applicable trades for compression along with their desired risk tolerance. The submitted trades are then matched to each counterparty and netted into a single contract. For example, consider an institution with three credit default swap (CDS) contracts for the same reference entity and maturity, but with different counterparties. In this case, the three trades can be compressed into a single net contract by netting out the long and short contracts and using the weighted average of the three contract coupons as the net contract coupon. Trade compression services, such as TriOptima, help reduce OTC derivatives exposures for various credit derivatives. In addition, recent changes to the CDS market, such as standard coupons and maturity dates, also help promote the benefits of trade compression.
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K e y C o n c e p t s
LO 25.1
Standardization of terms of OTC derivatives through the ISDA Master Agreement is a key way to mitigate credit risk to improve liquidity and reduce transaction costs.
LO 25.2
Netting involves combining the cash flows from different contracts with a counterparty into a single net amount (payment netting). Close-out netting refers to netting contract values with a counterparty if the counterparty defaults. Without netting, exposures are additive; with netting, exposures of trades are not additive.
Bilateral netting is limited to two entities only. Multilateral netting involves netting between multiple parties, usually with a central entity, such as an exchange or clearinghouse, handling the netting process.
LO 25.3
Netting arrangements are beneficial as long as trading instruments can have negative mark- to-market (MtM) values during their life. Netting for trades with the possibility of only positive exposures is generally not beneficial, although benefits can arise if future trades with negative MtM values could offset the positive MtM of these instruments.
LO 25.4
Walkaway clauses allow an entity to walk away from its liabilities to a counterparty that is in default, while still being able to make a claim on its own exposure. Trade compression reduces net exposure without the need to change the overall risk profile.
LO 25.5
Termination events allow institutions to terminate a trade before their counterparties become bankrupt. A break clause allows a party to terminate a trade at specified future dates at replacement values.
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C o n c e p t C h e c k e r s
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Riggs Resources, LLC, (Riggs) is a commodity trading firm. Riggs has numerous trades outstanding with several counterparties; however, it is concerned with presettlement risk. In order to reduce presettlement risk (the risk that Riggss counterparties would default before settlement), it would be most beneficial for Riggs to: A. have payment netting. B. have close-out netting. C. analyze potential losses as the sum of exposures. D. have netting but not set-off.
Entity XYZ is netting its trades with Entity ABC. Which of the following techniques best describe this type of netting arrangement? A. Multilateral netting. B. Bilateral netting. C. Close-out netting. D. Additive exposure netting.
Assume the following current MtM values for five different transactions for Entity ABC: +5, 4, +2, +3, and 6. What is the total exposure with and without netting, respectively? A. 0, 10. B. 20, 10. C. 10,0. D. 10,20.
Which of the following trading instruments would have the most beneficial effect on netting? A. Options with up-front premiums. B. Equity options. C. FX options. D. Futures.
Leverage, Inc., an investment bank, has numerous credit default swaps with XYZ Corp. Leverage has established a break clause with XYZ Corp. to reduce risk. The break clause is trigger-based and may be exercised once the trigger is satisfied. The CEO of Leverage is concerned about a bankers paradox. Which of the following statements best describe the CEOs concern? A. To be effective, the break clause option should not be used too early. B. The weak firm often recovers after the use of the break clause. C. The break clause option is used too late, and the weak firm gets weaker. D. The break clause option is used too early, and relations with the counterparty
suffer.
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C o n c e p t C h e c k e r An s w e r s
1. B To minimize presettlement risk, Riggs should have close-out netting. Under close-out,
contracts between solvent and insolvent counterparties are terminated and netted.
Payment netting would reduce settlement and operational risk, but not presettlement risk. Netting also means individual positive exposures are nonadditive. The terms netting and set- off are synonymous.
2. B Bilateral netting is a netting arrangement between two entities and is limited to two entities. Trades with multiple counterparties is known as multilateral netting. Close-out netting refers to netting contract values with a counterparty if the counterparty defaults.
3. A The total exposure with netting i s 0 ( 5 – 4 + 2 + 3 – 6 = 0), and the total exposure without
netting is 10 (5 + 2 + 3 = 10).
4. D A trading instrument will have a beneficial effect on netting if it can have a negative mark-to- market (MtM) value during its life. For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial. Instruments with only positive MtM values include options with up-front premiums such as equity options, as well as swaptions, caps and floors, and FX options. Futures can have negative MtM values.
5. C A break clause (also called a liquidity put or early termination option) allows a party to terminate a transaction at specified future dates at its replacement value. Despite their advantages, break clauses have not been highly popular. One explanation is known as banker s paradox, which implies that for a break clause to be truly useful, it should be exercised early on, prior to the substantial decline in a counterpartys credit quality. Entities, however, typically avoid early exercise to preserve their good relationships with counterparties.
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The following is a review of the Credit Risk Measurement and Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
C o l l a t e r a l
E x a m F o c u s
Topic 26
This topic examines collateral and introduces the types of collateral, the features of a collateralization agreement and a credit support annex (one-way and two-way), and the reconciliation of collateral disputes. For the exam, be familiar with the key parameters associated with collateral (e.g., threshold, initial margin, and minimum transfer amount). In addition, understand the risks associated with collateralization, focusing on market risk, operational risk, and funding liquidity risk.
C o l l a t e r a l M a n a g e m e n t

LO 25.4: Describe the mechanics o f termination provisions and trade compressions and explain their advantages and disadvantages.

LO 25.3: Describe the effectiveness o f netting in reducing credit exposure under various scenarios.
As we have previously discussed, netting can either reduce exposure to a counterparty or have no effect on exposure, but it can never increase it. We now look at netting in more detail, including the relationship between netting and exposure.
A trading instrument will have a beneficial effect on netting if it can have a negative mark-to-market (MtM) value during its life. For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial. Instruments with only positive MtM values include options with up-front premiums such as equity options, as well as swaptions, caps and floors, and FX options. Other instruments can have negative MtM value during their life; however, there is a greater likelihood that MtM will be positive. These instruments include long options without up-front premiums, certain interest rate swaps, certain FX forwards, cross-currency swaps, off-market instruments, and wrong-way instruments.
Despite these instruments having either only positive or mostly positive MtM values, it may still be worthwhile for an entity to include them under a netting agreement for the following reasons:

Future trades with negative MtM values could offset the positive MtM of these instruments. Inclusion of all trades is necessary for effective collateralization.
Netting is beneficial as it ensures that if these positions need to be unwound in the future
and an offsetting (mirror) trade is required, there will be no residual counterparty risk.
T e r m i n a t i o n F e a t u r e s

LO 25.2: Summarize netting and close-out procedures (including multilateral netting), explain their advantages and disadvantages, and describe how they fit into the framework o f the ISD A m aster agreement.
N etting and Close-O ut Between Two Counterparties
Netting, often called set-off, generally refers to combining the cash flows from different contracts with a counterparty into a single net amount. This is referred to as payment netting, which acts to reduce settlement risk while enhancing operational efficiency. A related concept is close-out netting, which refers to the netting of contract values with a counterparty in the event of the counterpartys default. The concepts of both netting and close-out incorporate two related rights under a single contract: (1) the right to terminate contracts unilaterally (by only one side) under certain conditions (close-out) and (2) the right to offset (net) amounts due at termination into a single sum.
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Before we examine close-out closer, it is important to discuss netting in more detail. Netting has enabled an explosive growth in credit exposures and notional values of trades, and it now covers most derivatives transactions. Institutions often have multiple trades with a counterparty, and these trades can constitute hedges whose values move in opposite directions, or they may constitute unwinds where a reverse trade of equal and opposite value has been executed with the same counterparty. Without netting, an entitys exposure of two equal and opposite trades is the positive mark-to-market exposure. For example, if an entity has two equal and opposite trades with a counterparty with mark-to-market values of + 10 and 10, without netting the total exposure is +10. This means that if the counterparty defaults, the value of the two trades is not netted, with the surviving entity having to make a settlement under the negative mark-to-market trade, while unable to collect on the positive one. Therefore, without netting, overall exposure is additive as the sum of the positive mark-to-market values. With netting, exposures of trades are not additive, which significantly reduces risk.
Netting has several advantages and disadvantages:

Exposure reduction: By offsetting exposures with parties managing net positions only, netting reduces risk and improves operational efficiency. Nevertheless, netted exposures can be volatile, which may result in difficulty in controlling exposure.
Unwinding positions’. If an entity wishes to exit a less liquid OTC trade with one
counterparty by entering into an offsetting position with another counterparty, the entity will remove market risk; however, it will be exposed to counterparty and operational risk. Netting removes these risks through executing a reverse position with the initial counterparty, removing both market and counterparty risk. The downside is that the initial counterparty, knowing that the entity is looking to exit a trade, may impose less favorable terms for the offsetting transaction.
Multiple positions’. An entity can reduce counterparty risk, obtain favorable trade

terms, and reduce collateral requirements by trading multiple positions with the same counterparty. Stability: Without netting, entities trading with insolvent or troubled counterparties would be motivated to cease trading and terminate existing contracts, exacerbating the financial distress of the counterparty. With netting, this risk is significantly reduced, and an agreement with a troubled counterparty is more achievable.
Netting agreements (specifically close-out netting) are legal agreements that become effective in the event of a counterpartys bankruptcy. As mentioned, netting agreements are often governed by the ISDA Master Agreement, which serves to eliminate legal uncertainties and reduce counterparty risk under a single legal contract with an indefinite term. A single universal agreement also helps avoid problems that may arise from different treatments of bankruptcy in different jurisdictions. For example, ISDA has obtained legal opinions for the Master Agreement in most jurisdictions. Agreements often cover bilateral netting, which is used for OTC derivative and repo transactions, and balance sheet loans and deposits. When no legal agreement exists that allows netting, exposures do not offset each other and are considered additive.
Close-out and netting become advantageous in derivatives transactions following the default of a counterparty when cash flows cease because these rights allow an entity to execute new replacement contracts. It is clear then that close-out arrangements protect the solvent, or surviving, entity. Note that close-out differs from an acceleration clause, which allows the creditor to accelerate (i.e., make immediately due) future payments given a credit event,
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such as a ratings downgrade. In contrast to acceleration, close-out clauses allow all contracts between a solvent and insolvent entity to be terminated, which effectively cancels the contracts and creates a claim for compensation. If the solvent entity has a negative mark- to-market exposure (it owes the insolvent entity), then the full payment is made to the insolvent entity. If the mark-to-market exposure is positive, the solvent entity becomes a creditor for that amount and can terminate and replace the contracts with another entity.
Both acceleration and close-out clauses have been criticized for making a debtors refinancing more difficult. Both clauses cause payment amounts to be immediately due and may speed up the financial distress of the insolvent entity. For this reason, courts may impose a stay (temporary suspension) on the agreements to allow for a short period of time out while maintaining the validity of the termination clauses.
Despite these criticisms, close-out clauses can be very advantageous to parties. Close-out limits the uncertainty in the value of an entitys position with an insolvent counterparty. Without close-out, an entity would have difficulty estimating to what degree positions offset each other because recovery of exposure is not known. With close-out, however, the solvent entity can fully re-hedge transactions with the insolvent entity while waiting to receive a claim. As a result, although the solvent entity may experience some risk loss, it would minimize market risk and trading uncertainty. In addition, close-out allows entities to freeze their exposures. Because these exposure amounts are known and will not fluctuate, the solvent entity can then better hedge this exposure.
Netting and Close-O ut Between M ultiple Counterparties
Up until this point, we have been discussing bilateral netting; that is, netting arrangements between two entities. Bilateral netting is important in reducing credit exposure; however, it is limited to two entities only. In reality, trades are often structured in a way where an entity trades with multiple counterparties (known as multilateral netting). For example, entity A can have exposure to B, entity B has the same exposure to entity C, and entity C has an identical exposure to entity A. The default of any of these entities would give rise to questions on how to allocate losses.
Under multilateral netting, netting arrangements would involve multiple counterparties to mitigate counterparty and operational risk. Typically, multilateral netting is achieved with a central entity, such as an exchange or clearinghouse, handling the netting process, including valuation, settlement, and collateralization. A disadvantage, however, is that this type of netting arrangement mutualizes counterparty risk and results in less incentive for entities to monitor each others credit qualities. In addition, multilateral netting can enable redundant trading positions to accumulate in the system, resulting in higher operational costs (this risk is reduced by firms that use algorithms to detect and reduce redundant positions). Finally, multilateral netting requires trading disclosure, which may be disadvantageous to firms wishing to keep proprietary information confidential.
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N e t t i n g E f f e c t i v e n e s s

LO 25.1: Explain the purpose o f an ISD A master agreement.
The International Swaps and Derivatives Association (ISDA) Master Agreement standardizes over-the-counter (OTC) agreements to reduce legal uncertainty and mitigate credit risk. This is accomplished by creating a framework that specifies OTC agreement terms and conditions related to collateral, netting, and termination events. The Master Agreement can cover multiple transactions by forming a single legal contract with an indefinite term.
N e t t i n g a n d C l o s e – O u t P r o c e d u r e s

LO 19.6: Compare agencies ratings to internal experts-based rating systems.
A rating agencys assignment processes will be different than the internal classification methods used by banks, even though the underlying processes are often analogous. Relative to a formal approach, such as quantitative analysis based on statistical models, experts-based approaches are neither considered to be inferior nor superior. An experts-based approach relying on judgment will require significant experience and repetitions in order for many judgments to converge. Also, the challenges of such an approach include the dynamic nature of organizational patterns; M&A activity, which blends portfolios and processes; and
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changing company cultures. A predictive performance that may work in one period is not necessarily indicative of future performance. Also, internal credit rating systems are difficult and time-consuming to develop. However, having a reliable internal system represents a significant value added for an entity.
In terms of the criteria for a good rating system discussed earlier, the following comparisons can be made between agencies ratings and internal experts-based rating systems:
Objectivity and Homogeneity. Agencies ratings are 73% compliant, while internal experts-

based rating systems are 30% compliant. Specificity. Agencies ratings are close to 100% compliant, while internal experts-based rating systems are 75% compliant.
Measurability and Verifiability. Agencies ratings are 75% compliant, while internal
experts-based rating systems are 25% compliant.
S t r u c t u r a l A p p r o a c h e s v s . R e d u c e d F o r m A p p r o a c h e s