Netting, Close-out and Related Aspects

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Vicky26

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The opposite signs of MTM is due to fact that each party owes some amount to another. Say A & B, where A defaults. A owed 20 to B and B owed 10 to A. Then MTM values for B are +20 and -10.
If correlation is high, then both MTM values will go up/down together. And thus Net value (+10 here) will move together. But, if correlation is low then one MTM moves up/down and other moves down/up. Say +20 gets to +21 and -10 gets to -9. Then the net value increases from +10 to +12. Which kind of exaggerates the net value in case of default.
I could not understand how low correlation benefits netting in the way it does in diversification.

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Hi @Vicky26! You're thinking about this correctly in terms of the mechanics, but what the slide is trying to convey is a bit more subtle. Let me walk through it.

The slide says netting only helps when the MtM values have opposite signs. That's the whole point. Netting collapses multiple exposures into a single net claim. If A owes B 20 and B owes A 10, the non-netted gross exposure for B is 20 (you only count what's owed to you, the positive side). With netting, it's only 10. That's the benefit.

Now here's where correlation comes in. Ask yourself: when does netting produce the biggest reduction in exposure?

It produces the biggest reduction when one trade is deeply in-the-money and another is deeply out-of-the-money at the same time, because that's when the offset is largest. For that to happen consistently, the MtM values need to move in opposite directions relative to each other, which is what negative (or low) correlation means in this context.

Here is how I think about it:

With high positive correlation, all MtM values tend to be positive together or negative together. The non-defaulting party either has a lot of gross exposure on everything, or nothing. The netting doesn't really help because there's rarely a large offsetting negative trade to cancel out the positive.
  • With low or negative correlation, one trade is likely up while another is likely down. That produces the opposite signs that make netting valuable. The net exposure is far lower than the gross.
Your example shows it nicely. When correlation is low and one goes to +21 while the other goes to -9, the net is +12. That is still well below the gross positive exposure of +21. Without netting, B would be a creditor for 21. With netting, only 12. So netting is still doing its job.

I think the confusion is that you are comparing the net figure over time, watching it rise, and thinking "that's bad." But the benchmark for netting is not the previous net, it's the gross exposure. The benefit of netting is always measured as: gross positive exposure minus net exposure. And that difference tends to be larger when correlation is low, because you're more likely to have large offsetting positions at any given moment.

It's the same logic as portfolio diversification in spirit: low correlation means the positions don't all move the same way, and that creates room for offsets to work their magic.

Kindly,
CC
 
So when correlation is low, +20 goes to +21 and -10 goes to -9 then net exposure is 12 which was 10 initially.
In case of positive correlation, +20 goes to +21 and -10 goes to -11 then new exposure remains 10....same as initial 10 exposure.
So in such case positive correlation is better in atleast keeping the exposure same. Then how is negative correlation better in case of netting.
 
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