Module: | MODULE B: RISK MANAGEMENT
Q372: Consider the following statements regarding Collateral Management and the ISDA Master Agreement in mitigating counterparty credit risk for trading book exposures:
1. The ISDA Master Agreement establishes a standardized legal framework that permits the close-out netting of multiple derivative transactions with a single defaulting counterparty.
2. Under the Credit Support Annex (CSA), counterparties exchange collateral strictly on a one-time basis at trade inception, without making adjustments for daily mark-to-market fluctuations.
3. When a bank applies a haircut to received collateral, it intentionally values the pledged asset at a discount to its current market price to buffer against potential future liquidation losses.
2. Under the Credit Support Annex (CSA), counterparties exchange collateral strictly on a one-time basis at trade inception, without making adjustments for daily mark-to-market fluctuations.
3. When a bank applies a haircut to received collateral, it intentionally values the pledged asset at a discount to its current market price to buffer against potential future liquidation losses.
✅ Correct Answer: C
The correct answer is C. Statement 1 is correct: The International Swaps and Derivatives Association (ISDA) Master Agreement is the global standard document for over-the-counter derivatives.
Its core risk-mitigating feature is close-out netting, which allows a non-defaulting party to terminate and net all outstanding transactions with a defaulting counterparty into a single payable or receivable sum, drastically reducing gross credit exposure.
Statement 3 is correct: A haircut is a risk control measure where the bank values collateral at less than its current market price.
For example, applying a 10 percent haircut to a 100 Rupees bond means recognizing its collateral value as only 90 Rupees, providing a buffer against price drops if the asset needs to be liquidated.
Statement 2 is incorrect: The Credit Support Annex (CSA) regulates collateral exchange under the ISDA agreement.
It strictly requires the dynamic, daily exchange of Variation Margin based on daily mark-to-market fluctuations, not just a static one-time Initial Margin exchange at the start of the trade.
Its core risk-mitigating feature is close-out netting, which allows a non-defaulting party to terminate and net all outstanding transactions with a defaulting counterparty into a single payable or receivable sum, drastically reducing gross credit exposure.
Statement 3 is correct: A haircut is a risk control measure where the bank values collateral at less than its current market price.
For example, applying a 10 percent haircut to a 100 Rupees bond means recognizing its collateral value as only 90 Rupees, providing a buffer against price drops if the asset needs to be liquidated.
Statement 2 is incorrect: The Credit Support Annex (CSA) regulates collateral exchange under the ISDA agreement.
It strictly requires the dynamic, daily exchange of Variation Margin based on daily mark-to-market fluctuations, not just a static one-time Initial Margin exchange at the start of the trade.