Learning Objectives: Describe central clearing of OTC derivatives and discuss the roles, mandate, advantages, and disadvantages of the central counterparty (CCP). Explain the margin requirements for both centrally-cleared and non-centrally-cleared derivatives. Define special purpose vehicles (SPVs), derivatives product companies (DPCs), monolines, and credit derivatives product companies (CDPCs) and describe the limitations of using them as risk-mitigating methods. Describe the approaches used and the challenges faced in modeling derivatives risk.
Questions:
24.26.1. Global Hedge Fund is a major participant in the over-the-counter (OTC) derivatives market, with a significant portfolio of credit default swaps (CDS) and other OTC derivative contracts. In the aftermath of the Global Financial Crisis (GFC), regulatory authorities have mandated the central clearing of standardized OTC derivative contracts through central counterparties (CCPs).
Given this regulatory environment and Global Hedge Fund's exposure to OTC derivatives, which of the following advantages of central clearing would likely be of utmost importance to the fund?
a. Reduced operational complexity due to the standardization of OTC derivative contracts facilitated by CCPs.
b. Increased market transparency and pricing insights provided by CCPs through the centralization of trade data.
c. Mitigation of counterparty credit risk and reduction of systemic risk exposure through the risk management mechanisms of CCPs.
d. Enhanced flexibility in structuring and customizing OTC derivative contracts, as CCPs can accommodate a wide range of non-standardized instruments.
24.26.2. Crestview Bank is a major participant in both the centrally cleared and over-the-counter (OTC) derivatives markets. Considering the regulatory changes introduced after the 2007-2008 financial crisis, the bank’s risk management team is reviewing its practices related to margin requirements and counterparty risk mitigation strategies.
Which of the following statements is accurate regarding margin requirements and counterparty risk mitigation strategies in the derivatives market?
a. For centrally cleared derivatives, the clearing house determines both the initial and variation margin, while for OTC derivatives, these margins are negotiated bilaterally between counterparties.
b. Variation margin is mandatory for centrally cleared derivatives but optional for non-centrally cleared OTC derivatives based on bilateral agreements between counterparties.
c. Crestview Bank can utilize Credit Derivatives Product Companies (CDPCs) to assume credit risk from its OTC derivative transactions, thereby mitigating counterparty credit risk exposure.
d. Initial margin is not required for centrally cleared derivatives as the clearing house acts as the central counterparty, but it is mandatory for non-centrally cleared OTC derivatives to mitigate counterparty credit risk.
24.26.3. Silverlake Bank is a major participant in the credit derivatives market, with a significant portfolio of credit default swaps (CDS) and collateralized debt obligations (CDOs). The bank's risk management team is tasked with accurately modeling the dependencies between interest rates and credit spreads, as these factors significantly impact the valuation and risk profile of their credit derivative positions.
Given the importance of capturing these dependencies, which of the following approaches should the risk management team prioritize for their credit derivative portfolio?
a. To simplify the dependency modeling process, use a single-factor Gaussian copula model, which assumes a linear correlation structure between interest rates and credit spreads.
b. Employ a t-copula function, which can better capture tail dependencies and extreme joint events compared to the Gaussian copula, especially during periods of market stress.
c. Rely on historical data and expert judgment to estimate the dependencies between interest rates and credit spreads without the use of copula functions.
d. Implement a combination of copula functions, scenario analysis, and stress testing to comprehensively model the dependencies, accounting for both linear and nonlinear relationships, as well as potential tail events.
Answers here:
Questions:
24.26.1. Global Hedge Fund is a major participant in the over-the-counter (OTC) derivatives market, with a significant portfolio of credit default swaps (CDS) and other OTC derivative contracts. In the aftermath of the Global Financial Crisis (GFC), regulatory authorities have mandated the central clearing of standardized OTC derivative contracts through central counterparties (CCPs).
Given this regulatory environment and Global Hedge Fund's exposure to OTC derivatives, which of the following advantages of central clearing would likely be of utmost importance to the fund?
a. Reduced operational complexity due to the standardization of OTC derivative contracts facilitated by CCPs.
b. Increased market transparency and pricing insights provided by CCPs through the centralization of trade data.
c. Mitigation of counterparty credit risk and reduction of systemic risk exposure through the risk management mechanisms of CCPs.
d. Enhanced flexibility in structuring and customizing OTC derivative contracts, as CCPs can accommodate a wide range of non-standardized instruments.
24.26.2. Crestview Bank is a major participant in both the centrally cleared and over-the-counter (OTC) derivatives markets. Considering the regulatory changes introduced after the 2007-2008 financial crisis, the bank’s risk management team is reviewing its practices related to margin requirements and counterparty risk mitigation strategies.
Which of the following statements is accurate regarding margin requirements and counterparty risk mitigation strategies in the derivatives market?
a. For centrally cleared derivatives, the clearing house determines both the initial and variation margin, while for OTC derivatives, these margins are negotiated bilaterally between counterparties.
b. Variation margin is mandatory for centrally cleared derivatives but optional for non-centrally cleared OTC derivatives based on bilateral agreements between counterparties.
c. Crestview Bank can utilize Credit Derivatives Product Companies (CDPCs) to assume credit risk from its OTC derivative transactions, thereby mitigating counterparty credit risk exposure.
d. Initial margin is not required for centrally cleared derivatives as the clearing house acts as the central counterparty, but it is mandatory for non-centrally cleared OTC derivatives to mitigate counterparty credit risk.
24.26.3. Silverlake Bank is a major participant in the credit derivatives market, with a significant portfolio of credit default swaps (CDS) and collateralized debt obligations (CDOs). The bank's risk management team is tasked with accurately modeling the dependencies between interest rates and credit spreads, as these factors significantly impact the valuation and risk profile of their credit derivative positions.
Given the importance of capturing these dependencies, which of the following approaches should the risk management team prioritize for their credit derivative portfolio?
a. To simplify the dependency modeling process, use a single-factor Gaussian copula model, which assumes a linear correlation structure between interest rates and credit spreads.
b. Employ a t-copula function, which can better capture tail dependencies and extreme joint events compared to the Gaussian copula, especially during periods of market stress.
c. Rely on historical data and expert judgment to estimate the dependencies between interest rates and credit spreads without the use of copula functions.
d. Implement a combination of copula functions, scenario analysis, and stress testing to comprehensively model the dependencies, accounting for both linear and nonlinear relationships, as well as potential tail events.
Answers here:
