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week 10;Chapter 13:Mitigating derivative counterparty credit risk, Chapter…
week 10;Chapter 13:Mitigating derivative counterparty credit risk
Difference between MTM and VAR
VAR
value at risk measure of counterparty credit risk is a forward-looking measure of the exposure associated with transaction
MTM
It fluctuates with the changes in the market value of product underlying the transaction
Mitigating counterparty risk through collaterlization
how to set the value of threshold
characteristics of collateral
3.Price stability
4.Correlation
Collateral must be uncorrelated with the transaction
2.Liquidity
5.Security interest
The party must have a perfected security interest in the collateral
1.credit quality
Another way to strength collateral
Haircut
formula of haircut
the amount of collateral: 100/100-2
threhold
Dealers Versus End- users
Dealer and end user
Bilateral transcation
use margin requirements to reduce credit risk
disadvantage of margin requirement
inefficient
2.systemic risk
resource intensive- people to manage and costly
Central transcation
CCC's advantage over Bilateral transaction
Ad:each party faces the credit risk of the clearinghouse
advantage
operational efficiencies, standardized collateral management, risk pooling
what is CCC: specialize in intermediating derivatives transaction, become legal counterparty of the two parties
drawback
high concentration risk and systematic risk
Difference Prime dealer and CCC
Prime brokers use Clearinghouses to conduct trading on behalf of their customers
Repo:
one party- borrower
sells a security and commits to buy back at a predetermined price and at a certain date
other party- lender
two risks
1.repurchased risk from borrower
price of security may drop
Chapter 15: credit insurance, surety bonds, an letter of credit
credit insurance
developer-obligee
surety
builder-principal
letter of credit
standby
evergreen-extend the term automatically
irrevocable
difference between letter of credit and surety bond
banks have limited credit capacity- L/C limit bank's borrowing amount
2.L/C are expensive
3.L/C are easily drawn by beneficiaries
surety bonds
contract bonds
commercial bonds
Chapter 14: structural mitigation
transaction with corporate
Negative
Incurrence covenant
a covenant to comply with only upon the occurrence of certain actions of the borrower
factors of impacting corporate borrower credit risk
1.the priority of payment
do not impact default probability
2.the security package
do not default probability
3.the covenant
restrictive covenants can increase default probability for a given time horizon
4.the definition of default
once the negative covenant is triggered
maintenance covenants
require to meet certain financial tests every reporting period
Affirmative
keep a legal existence, maintain its building
Transaction with SPV
2.credit enhancement
overcollateralization
early amortization
excess spread
third party guaranty
external enhancement
set different tranches
AA,A,B
week 10