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

A hedge fund trades OTC derivatives with a dealer under a credit support annex. The fund posts initial margin (IM) that the dealer must hold with a third-party custodian in a segregated account. What is the primary credit-risk benefit of this arrangement to the fund?

Segregating initial margin with a third-party custodian protects the poster if the dealer defaults, because the collateral is held outside the dealer's insolvency estate and remains recoverable. It does not remove variation margin, and it prevents the dealer from reusing the collateral.

  1. AThe fund's posted IM is protected from loss if the dealer defaults, because it is not part of the dealer's insolvency estateCorrect
  2. BThe dealer's exposure to the fund is eliminated because the IM earns interest
  3. CThe fund no longer has to post variation margin on its derivatives
  4. DThe IM can be freely rehypothecated by the dealer to fund its own trading book

Explanation

Segregation with a third-party custodian keeps the posted IM outside the dealer's bankruptcy estate, so the fund should recover it if the dealer defaults. It does not remove variation margin, and free rehypothecation is exactly what segregation prevents.

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