Dear David,
I’ve have struggling with the following question from FRM practice and past exams. Appreciate your kind help on this!
8) On Margining and Credit Exposure (FRM handbook 5th edition, Example 21.19 page 525)
You have purchased 10,000 barrels of oil for delivery in one year at a price of $25/barrel. The rate of change of the price of oil is assumed to be normally distributed with zero mean and annual volatility of 30%. Margin is to be paid within two days if the credit exposure becomes greater than $50,000. There are 252 business days in the ear. Assuming enforceability of the margin agreement, which of the following is the closet number to the 5% one-year credit risk of this deal governed under the margining agreement?
a. $50,000
b. $58,000
c. $61,000
d. $123,000
Answer provided: C$61,000 = 50,000 + 10,000 x 25 x 30% x 1.645x (2/252)^1/2
My question:
1) According to the text, margin requirements can cover potential exposure though the fact that contract gains and losses will be added to the posted margin. I think in any futures market, be it organized market or OTC market, margining serves to reduce credit exposure to the party with credit exposure (with positive contract value). The only difference I think is that the margining involves counterparty risks in the OTC market due to the OTC nature, but no such risk or much less risk in the organized market.
Given the above, I think this question should be more precisely set in an “OTC market” scenario; and more importantly, I’m wondering if the correct answer should be calculated as follows – to take into consideration the likely price movement during the 2-day period, the 5% one-year credit risk should only be the futures price VAR for the two-day period when the variation margin post is pending from the losing counterparty because the initial margin of $50,000 has already been posted
10,000 x 25 x 30% x 1.645x (2/252)^1/2 = 10991 (not 61,000)
Thank you for your enlightenment and correction!
Cheers
Liming
10/11/09
I’ve have struggling with the following question from FRM practice and past exams. Appreciate your kind help on this!
8) On Margining and Credit Exposure (FRM handbook 5th edition, Example 21.19 page 525)
You have purchased 10,000 barrels of oil for delivery in one year at a price of $25/barrel. The rate of change of the price of oil is assumed to be normally distributed with zero mean and annual volatility of 30%. Margin is to be paid within two days if the credit exposure becomes greater than $50,000. There are 252 business days in the ear. Assuming enforceability of the margin agreement, which of the following is the closet number to the 5% one-year credit risk of this deal governed under the margining agreement?
a. $50,000
b. $58,000
c. $61,000
d. $123,000
Answer provided: C$61,000 = 50,000 + 10,000 x 25 x 30% x 1.645x (2/252)^1/2
My question:
1) According to the text, margin requirements can cover potential exposure though the fact that contract gains and losses will be added to the posted margin. I think in any futures market, be it organized market or OTC market, margining serves to reduce credit exposure to the party with credit exposure (with positive contract value). The only difference I think is that the margining involves counterparty risks in the OTC market due to the OTC nature, but no such risk or much less risk in the organized market.
Given the above, I think this question should be more precisely set in an “OTC market” scenario; and more importantly, I’m wondering if the correct answer should be calculated as follows – to take into consideration the likely price movement during the 2-day period, the 5% one-year credit risk should only be the futures price VAR for the two-day period when the variation margin post is pending from the losing counterparty because the initial margin of $50,000 has already been posted
10,000 x 25 x 30% x 1.645x (2/252)^1/2 = 10991 (not 61,000)
Thank you for your enlightenment and correction!
Cheers
Liming
10/11/09
