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

Under a margin agreement a counterparty may post either cash or a mix of securities, choosing whichever it wishes each day. Which risk does this cheapest-to-deliver collateral option most directly create for the collateral receiver?

The receiver may end up holding the least liquid or most volatile eligible assets, since the poster chooses what to deliver. Haircuts and eligibility limits should therefore be calibrated to the worst eligible collateral, because daily revaluation does not eliminate losses during liquidation.

  1. AThe receiver may be left with the least liquid or most volatile eligible assets, so haircuts should reflect the worst eligible assetCorrect
  2. BThe receiver will always hold cash, eliminating liquidity risk
  3. CThe receiver bears no market risk because collateral is revalued daily
  4. DThe receiver's exposure is increased by the amount of the haircut

Explanation

A substitution right lets the poster deliver the asset most favourable to itself, typically the one the receiver would least like to liquidate. Collateral terms should therefore be assessed against the worst eligible asset. Daily revaluation does not remove liquidation-period risk.

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