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

A bank's exposure to a counterparty is USD 30 million. Collateral held is USD 28 million of a bond market value, with a 6% haircut applied. The bank uses the haircut to compute the effective collateral. The bond subsequently loses 15% in value during liquidation after the counterparty defaults, and exposure is unchanged. Ignoring other costs, what is the bank's loss?

The loss is USD 6.20 million. The bond collateral of USD 28 million falls 15% to USD 23.80 million in liquidation, leaving a shortfall against the USD 30 million exposure. The 6% haircut was too small to absorb a 15% decline and did not add collateral.

  1. AUSD 0.00 million, since the haircut covers the decline
  2. BUSD 2.00 million
  3. CUSD 6.20 millionCorrect
  4. DUSD 3.80 million

Explanation

Actual proceeds = 28 x 0.85 = USD 23.80 million. Loss = 30 - 23.80 = USD 6.20 million. The haircut only determined the credited amount in margin calls; with collateral already posted at USD 28 million market value, the 6% haircut did not increase the collateral held, and the 15% fall exceeded it. USD 3.80 million would use 28 x 0.94 = 26.32 incorrectly mixed; USD 2.00 million ignores the fall.

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