Credit risk mitigation options security ranking

[[email protected]]

Hi David

2003 FRM exam
Credit risk mitigation options security ranking
1) Cash
2) Letter of credit
3) Securities as collateral (which a hair cut parameter of 0%)
4) Parental guarantees

Why LC is ranked higher than securities which has a hair cut parameter of 0% ( 0% hair cut is normally for securities issued or guaranteed by government and gold)? Your advice, please.


Regards
Learning

 

[David Harper CFA FRM]

Hi Learning,

Please see answer #2 here: http://forum.bionicturtle.com/viewthread/1039/
Per Culp, the LOC is (consisently in the FRM, i think) treated as a very strong mitigant, it is "above" credit insurance even because it "represents the financial captial of the obligee that has been simply guaranteed by a bank" (the "exporter" would be the "obligee" in #2). I don't know why the answer gives securities a haircut of 0% (??) instead of (eg.) 15% but I *think* the securities would still be subject to market risk (i.e., loss in value) where presumably the standby LOC could be drawn on fixed value of $X (but even with LOC, more precision would be helpful; e.g., it would be easier if it said "standby LOC from AAA rated bank")

David

p.s. you know, that 0% haircut on securities looks positively ancient-yes? it's off the topic, but I just wanted to remind you about Gary Gorton's reading about the 2007 panic where he compares pre-crisis haircut on structured securiteis (e.g., CDOs, ABS) that were typically 0% before July 2007 but are now 20% - 25% or "no financing"... the 0% securities haircut struck me as odd, but then i realized the question pre-dates the crisis