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

A firm accepts a bond as collateral under a CSA. The bond has a market value of USD 10 million and the agreed haircut is 8%. For which purpose does the collateral taker use the haircut when calculating credit for the collateral?

The haircut cuts the credited collateral value to 9.2 million, which is 10 million times 92%. It protects the collateral taker against a fall in the bond's price or liquidity problems between the last margin call and liquidation after a default.

  1. AIt adds USD 0.8 million to the collateral value to compensate for funding costs
  2. BIt values the collateral at USD 9.2 million to protect against a decline in its value during the close-out periodCorrect
  3. CIt values the collateral at USD 10.8 million to reflect expected coupon income
  4. DIt reduces the exposure by 8% regardless of collateral value

Explanation

A haircut reduces the credited value of collateral to allow for price falls and liquidation risk between the last margin call and liquidation. Credit given is 10 x (1 - 0.08) = 9.2 million. Adding the haircut would overstate protection.

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