Counterparty Risk: Margins [Jorian FRM Handbook Example 21.19]

[mikey10011]

David, I am going through Jorian FRM Handbook Example 21.19 (p. 495) and am having difficutly seeing the "physics" (or "economics") of his answer (p. 499). Specifically I thought that margin requirements were to *decrease* credit exposure--but here in this example he *added* it to the daily credit VaR thereby *increasing* credit exposure. Could you explain the mistake in my understanding?

 

[David Harper CFA FRM]

Hi Mikey,

I agree with your characterization of margin, and frankly, I am vexed by the question too.

I *assume* (?) it refers to a forward not a futures contract due to the credit risk; i.e., as the spot price of oil increases the long is profiting but due to lack of daily settlement (and a futures exchange), the long is incurring counterpary (credit) risk.

So, based on the answer, I'd *guess* that the CaR-based credit exposure refers to the scenario where the long is "in the money" at $50,000 (credit risk that must wait for settlement) then the spot price can increase and the margin call is initiated on the short position (not on the long).

But it's unsatisfying: 1. if the 50,000 is the maintenance margin, why is that the mean credit exposure, and 2. to your point, this treats the short's margin call as counterparty risk for the long.

All in, i don't follow the question either, sorry...would love some help here if somebody grasps the meaning of this?

David

 

[rahul.goyl]

Hi David,
I think we are just missing the below statement "Assuming enforceability of the margin agreement"
"Assuming enforceability of the margin agreement, which of the
following is the closest number to the 95% one-year credit risk of this deal
governed under the margining agreement?"

The worst credit exposure is the $50,000 plus the worst move over two days at
the 95% level. The worst potential move is ασ

T = 1.645 × 30% × √(2/252) = 4.40%.
Applied to the position worth $250,000, this gives a worst move of
$10,991. Adding this to $50,000 gives $60,991.

I don't see a problem here....

Thanks

 

[David Harper CFA FRM]

Hi Rahul,

Right, understood, but: how can you add the $10,991 to $50,000?
This would seem to assume that $50,000 is the mean, and we are adding the 95th %ile move; or, put another way, the $50,000 is a trigger for the margin, by what logic is it added to the 95th %ile worst move to produce a 95th %ile credit risk? Yea, i still don't see it: we have no information on how the $50,000 relates to the distributional assumption, so this question continues to look sloppy-wrong to me (I could be wrong...) e.g., $50,000 might already lie outside the 95th %ile, in which case the 95th %ile credit risk would be $50,000!

David

P.S. the answer, to my thinking, works only if we can assume the expected (mean) credit exposure = (maintainence) margin trigger = $50,000 but i don't see why that assumption can be made