Credit Risk - Gregory - Chapter 5 - Notion of "Independent amount"

[MissJaguar]

Dear BT Team

Would you please clarify a bit the notion of independent amount as per study notes (pages 32-33)? I am missing something here as it is stated

(1) independent amount (IA) is a negative threshold
(2) conceptually, IA is similar to initial margin
(3) the threshold represents uncollateralized exposure (basically not covered, backed up exposure).

The above statements are somewhat contradictory.

Would you be kind to put some light here?

Thanks, as always

 

[Basu]

(3) I will start with your 3rd question first. Suppose that the two sides to a transaction are Party A and Party B and Party B is required to post collateral. The threshold is the unsecured credit exposure to Party B that Party A is willing to bear.

For example, let's say that Party B has to post collateral only if exposure of Party A is greater than $25m. Then if exposure of A is $20m, then B does not have to post any collateral since it is below the threshold of $25m. That means if B were to default, A would not have any security from B to sell to offset some of its exposure to B. However, credit exposure for A is $50m then B will have to post collateral of $25m. In this case, A can sell $25m of collateral provided by B if B defaults. Note however that $25m of remaining exposure for A is still at risk and not collateralized for A (uncollateralised exposure).

If the threshold, however, was zero rather than $20m, B would have to post $20m collateral in the first case and $50m in the second case and there would not be any uncollateralised exposure for A.

(1) (2) The independent amount (IA) is an amount of extra collateral that must be posted irrespective of the exposure. Basically IA is a cushion against the risk of counterparty defaulting. This is common for counterparties with relatively poor credit quality. An example: Suppose X has to post $100m as independent amount to Y irrespective of the credit exposure. This means that Y would not suffer any loss until Y's exposure crosses $100m. This is similar to Initial margin that needs to be provided in an exchange traded transaction.
More on Initial margin (http://www.investopedia.com/university/futures/futures4.asp)

You will note that threshold creates an uncollateralised exposure while IA creates over collateralisation, hence these two concepts are opposite of each other. Therefore IA = negative threshold.

Thanks,
Basu

 

[MissJaguar]

Dear Basu

Thank you *very* much for your time to provide this explanation to me.

I appologize for delay in reading and my "thank you" note - work was a bit hectic.

In case you are to sit for L2 2015, I wish you best of luck,
Thanks a lot again!

 

[Basu]

Thank you @MissJaguar. Yes I am sitting for L2 in May. Wish you best of luck for the exam too.

 

[MissJaguar]

I am positive you will pass - in the end, you are the one who answers questions, not asks them, heheh

Best