Skip to content

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

A bank has a derivative exposure to a counterparty, a regional energy producer, and accepts shares of that same producer as collateral. Which risk is most directly illustrated, and what is the most appropriate mitigation?

This is specific wrong-way risk, because the collateral's value falls just when the counterparty is likely to default. The best mitigation is to disallow the counterparty's own shares as collateral or apply a very large haircut, rather than lowering it.

  1. ASpecific wrong-way risk; reject the shares as eligible collateral or apply a very large haircutCorrect
  2. BGeneral wrong-way risk; increase the margin period of risk only
  3. CRight-way risk; reduce the haircut on the shares
  4. DSettlement risk; move to delivery-versus-payment settlement

Explanation

Collateral issued by the counterparty itself loses value precisely when the counterparty is likely to default, so the link is direct and specific. The usual response is to exclude such collateral or apply a punitive haircut. Right-way risk would mean the opposite relationship, and DVP addresses settlement timing, not this correlation.

Did you get it right without looking?

One question tells you little. A timed set on Margin (Collateral) and Settlement shows your real accuracy, how long you take and where you lose marks.

Practise Margin (Collateral) and SettlementFree diagnostic mock

More Margin (Collateral) and Settlement questions