Skip to content

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

A dealer and a hedge fund trade bilateral OTC derivatives. The dealer posts initial margin to the hedge fund under a regulatory framework that requires the collateral to be held by a third-party custodian. What is the primary risk-reduction purpose of requiring segregation of this initial margin with a third party?

Segregating initial margin with a third-party custodian protects the posting party if the receiver defaults, because the collateral stays outside the receiver's insolvency estate and the poster is not left as an unsecured creditor. It does not replace variation margin or remove collateral market risk.

  1. AIt protects the posting party's collateral from loss if the receiving party defaults, since the collateral is not part of the receiver's insolvency estateCorrect
  2. BIt eliminates the need for variation margin because exposures are fully covered
  3. CIt allows the receiving party to reuse the collateral freely to fund its own trading
  4. DIt removes market risk on the collateral by guaranteeing its value

Explanation

Segregation with a third-party custodian keeps initial margin outside the receiver's bankruptcy estate, so the poster is not an unsecured creditor for the return of its collateral. It does not replace variation margin, permit reuse, or remove collateral price risk.

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