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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A bank accepts a corporate bond as collateral against a derivatives exposure and applies a haircut to its market value. What is the primary purpose of this haircut?

The haircut protects the collateral taker from a fall in the collateral's value between the last valuation and its liquidation after a counterparty default. Giving credit for less than market value creates a buffer against price volatility and liquidation costs during the close-out period.

  1. ATo compensate the collateral provider for the interest it forgoes on the pledged asset
  2. BTo protect the collateral taker against a fall in the collateral's value between the last valuation and liquidation after a defaultCorrect
  3. CTo reduce the threshold amount so that margin calls occur more often
  4. DTo offset the credit valuation adjustment charged on the trade

Explanation

A haircut reduces the credit given for collateral so that, if the counterparty defaults, a decline in the asset's price during the close-out and liquidation period does not leave the taker undercollateralised. It is not an interest compensation mechanism, and it does not change thresholds or CVA.

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