Funding liquidity risk

[Arka Bose]

How can funding liquidity risk be converted from counter party risk? I can't get it in Gregory Chapter 5. Also, can anyone clear me on this' the institution will incur a funding cost when uncollateralized trade moves in their favor and experience a benefit when reverse happens'.

 

[QuantMan2318]

How can funding liquidity risk be converted from counter party risk? I can't get it in Gregory Chapter 5. .

The counterparty risk, the risk that the party opposite our netted transaction will default can be mitigated by collateralization. However, accepting collateral is a double edged sword as it does not mitigate all risks completely, it merely converts the counterparty risk into Funding Liquidity Risk. This conversion of one risk into another happens when the collateral is idle. Therefore, the conversion to Funding liquidity does not happen when we rehypothecate the collateral.

The rehypothecation of collateral reduces our funding costs and hence our funding liquidity risk as we may be a party in another transaction where the trade may move against us and we have to post a collateral as a counterparty to another institution. If the collateral is idle, we have to secure funding from external sources that may significantly increase the cost of funding, if the trade moves are particularly negative, we may even face the risk of not settling our margin calls, hence the funding liquidity risk

Also, can anyone clear me on this' the institution will incur a funding cost when uncollateralized trade moves in their favor and experience a benefit when reverse happens'

This is where Gregory shows that he is a master of Credit Risk! Suppose I am A and you are B and we have a transaction between ourselves, you hedge this transaction with an opposite transaction subject to a CSA and its associated collateral postings/margin calls. Note that our transaction is without collateral as I have made it clear to you that I do not want the burden of collateral posting/management. Now when the transaction between ourselves moves in your favor, the hedge would obviously be negative to you and you would be required to post collateral, as the original transaction is without collateral and hence no scope for rehypothecation, you would have to draw deep to post the collateral on the Hedge and hence your increase in funding costs

Hope the above helped!
Thanks

 

[Arka Bose]

Thanks @QuantMan2318 was getting it but still it was cloudy. Your explanation cleared it!