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

A bank accepts corporate bonds as collateral under a margin agreement. The bonds are valued at market price, but the bank applies a haircut to their value before crediting them against the counterparty's exposure. What is the primary purpose of this haircut?

The haircut protects the bank against a drop in the collateral's market value between the last valuation and the time the collateral can be liquidated after a default. It covers price volatility and liquidation risk, not funding costs or the counterparty's credit spread.

  1. ATo protect against a fall in the collateral's value between the last margin call and the close-out of the positionCorrect
  2. BTo compensate the bank for the funding cost of holding the collateral
  3. CTo reflect the counterparty's credit spread on its own senior debt
  4. DTo remove the effect of interest paid on cash collateral

Explanation

A haircut reduces the credit given for non-cash collateral so that adverse price moves during the margin period of risk and liquidation do not leave the bank under-collateralised. Funding cost and counterparty spreads are handled through other mechanisms such as collateral interest rates or valuation adjustments.

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