Credit Risk Management Counterparty Credit Risk 2 — Questions and Answers
Question 1: Which of the following is a key advantage of central clearing through a Central Counterparty (CCP) for OTC derivatives?
- Elimination of all market risk in the cleared portfolio
- Reduction of bilateral counterparty credit risk through multilateral netting and default management (Correct answer)
- Removal of margin requirements for cleared transactions
- Transfer of legal documentation risk to the CCP
Correct answer: Reduction of bilateral counterparty credit risk through multilateral netting and default management
CCPs reduce bilateral counterparty credit risk by interposing themselves as buyer to every seller and seller to every buyer, enabling multilateral netting and standardized default management.
Question 2: Debit Value Adjustment (DVA) in derivatives pricing accounts for:
- The credit risk of the counterparty to the bank
- The bank's own credit risk as viewed from the counterparty's perspective (Correct answer)
- Changes in the risk-free discount rate over the trade's life
- The expected recovery rate on collateral held by the bank
Correct answer: The bank's own credit risk as viewed from the counterparty's perspective
DVA reflects the value of the bank's own default risk to the counterparty — it is the benefit the bank receives because it could default on its obligations.
Question 3: Under Basel III, the Standardized Approach for Counterparty Credit Risk (SA-CCR) replaced the Current Exposure Method primarily because:
- It reduced capital requirements across all asset classes
- It better recognizes the risk-reducing effects of netting, collateral, and hedging (Correct answer)
- It eliminated the need for computing potential future exposure add-ons
- It required financial institutions to use internal models for all derivative exposures
Correct answer: It better recognizes the risk-reducing effects of netting, collateral, and hedging
SA-CCR was designed to more accurately reflect actual exposures by properly accounting for netting, collateral, and market risk factors across asset classes.
Question 4: What is the primary purpose of an Initial Margin (IM) in bilateral OTC derivatives?
- To compensate the counterparty for the bid-ask spread on the trade
- To cover potential future exposure from the time of default to the close-out of positions (Correct answer)
- To fund the settlement of daily profit and loss between counterparties
- To meet regulatory minimum capital requirements for the bank
Correct answer: To cover potential future exposure from the time of default to the close-out of positions
Initial margin protects against the market risk of a portfolio during the margin period of risk (MPOR) — the period between a counterparty's last collateral posting and the close-out of positions after default.
Question 5: Variation Margin (VM) in OTC derivatives is exchanged to:
- Cover exposure that might arise over the life of the trade
- Settle the daily mark-to-market changes in portfolio value (Correct answer)
- Compensate for credit spread widening of the counterparty
- Meet initial posting requirements at trade inception
Correct answer: Settle the daily mark-to-market changes in portfolio value
Variation margin is collected or paid daily (or intraday) to reflect the current mark-to-market value of the portfolio, keeping net exposure near zero.
Question 6: In counterparty credit risk, the Margin Period of Risk (MPOR) is defined as:
- The duration over which a credit derivative provides protection
- The time from the last margin call to the completion of close-out and re-hedging after a counterparty default (Correct answer)
- The period during which a collateral agreement is legally contested
- The maximum tenor of a transaction eligible for netting under an ISDA agreement
Correct answer: The time from the last margin call to the completion of close-out and re-hedging after a counterparty default
MPOR represents the time window during which exposure is unhedged after a counterparty defaults — regulators require a minimum MPOR of 10 business days for most collateralized OTC transactions.
Question 7: Specific Wrong-Way Risk (SWWR) differs from General Wrong-Way Risk (GWWR) in that SWWR:
- Applies only to sovereign counterparties and not corporate entities
- Arises from a legal or contractual link between the counterparty's default and the exposure value (Correct answer)
- Is driven by macroeconomic correlation between market variables and credit quality
- Requires a Monte Carlo simulation to measure accurately
Correct answer: Arises from a legal or contractual link between the counterparty's default and the exposure value
SWWR occurs when there is a direct legal or contractual relationship causing exposure to spike upon the counterparty's default, such as a put option written by the counterparty on its own stock.
Credit Risk Management Counterparty Credit Risk 2
Which of the following is a key advantage of central clearing through a Central Counterparty (CCP) for OTC derivatives?