Learning Objectives: Define derivatives and explain how derivative transactions create counterparty credit risk. Compare and contrast exchange-traded derivatives and over-the-counter (OTC) derivatives, and discuss the features of their markets. Describe the process of clearing a derivative transaction.
Questions:
24.24.1. G Corporation has entered into an over-the-counter (OTC) interest rate swap agreement with Sunset Financial Bank to hedge against fluctuations in interest rates. The swap has a notional value of $50 million and a remaining maturity of 3 years.
Currently, the mark-to-market value of the swap favors G Corporation, meaning that Sunset Financial Bank is the "out-of-the-money" party. However, recent market developments have raised concerns about Sunset Financial Bank's creditworthiness, increasing G Corporation's counterparty credit risk.
Which of the following actions would be the most appropriate for G Corporation to mitigate the counterparty credit risk associated with this swap agreement?
a. Terminate the swap agreement immediately to eliminate the counterparty credit risk exposure.
b. Request Sunset Financial Bank to post additional collateral to secure the potential future exposure.
c. Negotiate a central clearing arrangement for the swap agreement to transfer the counterparty credit risk to a central counterparty.
d. Increase the frequency of mark-to-market valuations to monitor the exposure more closely.
24.24.2. Robot Inc., a large manufacturing company, is considering entering into a derivative contract to hedge its exposure to fluctuations in commodity prices. The company is evaluating two options: an exchange-traded commodity futures contract and an OTC commodity swap agreement with a major bank.
Which of the following statements accurately describes a key difference between these two derivative options?
a. The exchange-traded commodity futures contract would be subject to less regulatory oversight compared to the OTC commodity swap agreement.
b. Robot Inc. would have more flexibility to customize the terms of the exchange-traded commodity futures contract compared to the OTC commodity swap agreement.
c. Robot Inc. would face higher counterparty risk in the exchange-traded commodity futures contract than in the OTC commodity swap agreement.
d. Robot Inc. would be required to post collateral for daily margining purposes if it enters into the exchange-traded commodity futures contract but not for the OTC commodity swap agreement.
24.24.3. Lay Corporation has entered into an over-the-counter (OTC) interest rate swap agreement with a major bank to hedge its exposure to fluctuations in interest rates. The swap has a notional value of $100 million and a remaining maturity of 5 years.
Which of the following statements accurately describes the clearing process for this OTC derivative transaction?
a. The transaction will be centrally cleared through a clearinghouse, where the clearinghouse becomes the central counterparty to both Lay Corporation and the bank, managing counterparty risk and margin requirements.
b. Lay Corporation and the bank will be responsible for bilaterally clearing the transaction, including negotiating collateral and margin requirements, as well as managing counterparty risk exposure.
c. The clearing process is not applicable for OTC derivative transactions, as these are privately negotiated contracts between the two parties without the involvement of a third-party intermediary.
d. The clearing process will involve Lay Corporation reporting the transaction details to a regulatory authority, which will then assess and collect initial and variation margins from both parties throughout the life of the swap agreement.
Answers here:
Questions:
24.24.1. G Corporation has entered into an over-the-counter (OTC) interest rate swap agreement with Sunset Financial Bank to hedge against fluctuations in interest rates. The swap has a notional value of $50 million and a remaining maturity of 3 years.
Currently, the mark-to-market value of the swap favors G Corporation, meaning that Sunset Financial Bank is the "out-of-the-money" party. However, recent market developments have raised concerns about Sunset Financial Bank's creditworthiness, increasing G Corporation's counterparty credit risk.
Which of the following actions would be the most appropriate for G Corporation to mitigate the counterparty credit risk associated with this swap agreement?
a. Terminate the swap agreement immediately to eliminate the counterparty credit risk exposure.
b. Request Sunset Financial Bank to post additional collateral to secure the potential future exposure.
c. Negotiate a central clearing arrangement for the swap agreement to transfer the counterparty credit risk to a central counterparty.
d. Increase the frequency of mark-to-market valuations to monitor the exposure more closely.
24.24.2. Robot Inc., a large manufacturing company, is considering entering into a derivative contract to hedge its exposure to fluctuations in commodity prices. The company is evaluating two options: an exchange-traded commodity futures contract and an OTC commodity swap agreement with a major bank.
Which of the following statements accurately describes a key difference between these two derivative options?
a. The exchange-traded commodity futures contract would be subject to less regulatory oversight compared to the OTC commodity swap agreement.
b. Robot Inc. would have more flexibility to customize the terms of the exchange-traded commodity futures contract compared to the OTC commodity swap agreement.
c. Robot Inc. would face higher counterparty risk in the exchange-traded commodity futures contract than in the OTC commodity swap agreement.
d. Robot Inc. would be required to post collateral for daily margining purposes if it enters into the exchange-traded commodity futures contract but not for the OTC commodity swap agreement.
24.24.3. Lay Corporation has entered into an over-the-counter (OTC) interest rate swap agreement with a major bank to hedge its exposure to fluctuations in interest rates. The swap has a notional value of $100 million and a remaining maturity of 5 years.
Which of the following statements accurately describes the clearing process for this OTC derivative transaction?
a. The transaction will be centrally cleared through a clearinghouse, where the clearinghouse becomes the central counterparty to both Lay Corporation and the bank, managing counterparty risk and margin requirements.
b. Lay Corporation and the bank will be responsible for bilaterally clearing the transaction, including negotiating collateral and margin requirements, as well as managing counterparty risk exposure.
c. The clearing process is not applicable for OTC derivative transactions, as these are privately negotiated contracts between the two parties without the involvement of a third-party intermediary.
d. The clearing process will involve Lay Corporation reporting the transaction details to a regulatory authority, which will then assess and collect initial and variation margins from both parties throughout the life of the swap agreement.
Answers here:
