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

A bank holds a bond as collateral valued at USD 50 million market value and applies a 10% haircut. The bond is posted against a derivative exposure. What is the maximum exposure the collateral covers, and what is the primary purpose of the haircut?

The collateral gives credit of USD 45 million, which is 50 million reduced by the 10% haircut. The haircut exists to protect the collateral taker against adverse price moves in the collateral during the close-out and liquidation period, not to cover funding costs or coupons.

  1. AUSD 45 million; to protect against a fall in collateral value during the close-out periodCorrect
  2. BUSD 55 million; to compensate for the cost of funding the collateral
  3. CUSD 45 million; to compensate the poster for lost coupon income
  4. DUSD 50 million; to cover the margin period of risk of the derivative

Explanation

Collateral value after haircut = 50 x (1 - 0.10) = 45 million. The haircut guards against the collateral price falling between the last margin call and liquidation, particularly for volatile or illiquid securities. Adding the haircut to the value (55) is the wrong sign.

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