Learning Objectives: Identify the participants and describe the use of collateralization in the derivatives market. Define the International Swaps and Derivatives Association (ISDA) Master Agreement, the risk-mitigating features it provides, and the default events it covers. • Describe the features and use of credit derivatives and discuss potential risks they may create.
Questions:
24.25.1. Harder Manufacturing has two options:
a. Collateralization is not required for the exchange-traded commodity futures contract, as the exchange's clearinghouse acts as the central counterparty, mitigating counterparty risk.
b. If Harder Manufacturing chooses the OTC commodity swap agreement, it will need to post initial and variation margins as collateral to mitigate counterparty risk with the bank.
c. Both the exchange-traded commodity futures contract and the OTC commodity swap agreement require the posting of collateral, but the collateral requirements are standardized for the exchange-traded contract.
d. Collateralization is not necessary for either option, as Harder Manufacturing is a medium-sized player and is primarily using the derivative for hedging purposes.
24.25.2. Globex Corporation, a multinational company, has entered into several OTC interest rate swap agreements with various banks to hedge its exposure to fluctuating interest rates. To ensure legal certainty and risk management, Globex Corporation requires each counterparty bank to sign an ISDA Master Agreement before executing any derivative transactions.
Which of the following statements accurately describes a key risk-mitigating feature of the ISDA Master Agreement in this scenario?
a. The ISDA Master Agreement eliminates the need for Globex Corporation to post collateral or margin requirements for the OTC derivative transactions with the banks.
b. In the event of a default by one of the counterparty banks, the ISDA Master Agreement allows Globex Corporation to net all outstanding transactions with that bank to a single payment obligation, reducing the overall credit exposure.
c. The ISDA Master Agreement standardizes the pricing and valuation methodologies for the interest rate swap agreements between Globex Corporation and the banks, ensuring consistency across all transactions.
d. The ISDA Master Agreement specifies the legal jurisdiction and governing laws that Globex Corporation and the banks must adhere to, mitigating the risk of conflicting legal interpretations across different countries.
24.25.3. Global Manufacturing Corp. has entered into an interest rate swap agreement with Acme Bank to hedge its exposure to fluctuating interest rates on its floating-rate debt. The swap has a notional value of $100 million and a remaining maturity of 5 years. Global Manufacturing Corp. and Acme Bank have agreed to daily exchange of variation margin to mitigate counterparty credit risk.
Which of the following risks is Global Manufacturing Corp. most likely to face by engaging in this collateralized interest rate swap transaction?
a. Market risk arising from potential changes in interest rates that could impact the valuation of the swap position.
b. Credit risk due to the possibility of Acme Bank defaulting on its obligations under the swap agreement.
c. Operational risk stemming from the processes involved in regularly exchanging variation margin with Acme Bank.
d. Asset liquidity risk associated with the potential need to liquidate the collateral assets posted to Acme Bank in case of a default event.
Answers here:
Questions:
24.25.1. Harder Manufacturing has two options:
- An exchange-traded commodity futures contract traded on a regulated exchange.
- An over-the-counter (OTC) commodity swap agreement with a major bank
a. Collateralization is not required for the exchange-traded commodity futures contract, as the exchange's clearinghouse acts as the central counterparty, mitigating counterparty risk.
b. If Harder Manufacturing chooses the OTC commodity swap agreement, it will need to post initial and variation margins as collateral to mitigate counterparty risk with the bank.
c. Both the exchange-traded commodity futures contract and the OTC commodity swap agreement require the posting of collateral, but the collateral requirements are standardized for the exchange-traded contract.
d. Collateralization is not necessary for either option, as Harder Manufacturing is a medium-sized player and is primarily using the derivative for hedging purposes.
24.25.2. Globex Corporation, a multinational company, has entered into several OTC interest rate swap agreements with various banks to hedge its exposure to fluctuating interest rates. To ensure legal certainty and risk management, Globex Corporation requires each counterparty bank to sign an ISDA Master Agreement before executing any derivative transactions.
Which of the following statements accurately describes a key risk-mitigating feature of the ISDA Master Agreement in this scenario?
a. The ISDA Master Agreement eliminates the need for Globex Corporation to post collateral or margin requirements for the OTC derivative transactions with the banks.
b. In the event of a default by one of the counterparty banks, the ISDA Master Agreement allows Globex Corporation to net all outstanding transactions with that bank to a single payment obligation, reducing the overall credit exposure.
c. The ISDA Master Agreement standardizes the pricing and valuation methodologies for the interest rate swap agreements between Globex Corporation and the banks, ensuring consistency across all transactions.
d. The ISDA Master Agreement specifies the legal jurisdiction and governing laws that Globex Corporation and the banks must adhere to, mitigating the risk of conflicting legal interpretations across different countries.
24.25.3. Global Manufacturing Corp. has entered into an interest rate swap agreement with Acme Bank to hedge its exposure to fluctuating interest rates on its floating-rate debt. The swap has a notional value of $100 million and a remaining maturity of 5 years. Global Manufacturing Corp. and Acme Bank have agreed to daily exchange of variation margin to mitigate counterparty credit risk.
Which of the following risks is Global Manufacturing Corp. most likely to face by engaging in this collateralized interest rate swap transaction?
a. Market risk arising from potential changes in interest rates that could impact the valuation of the swap position.
b. Credit risk due to the possibility of Acme Bank defaulting on its obligations under the swap agreement.
c. Operational risk stemming from the processes involved in regularly exchanging variation margin with Acme Bank.
d. Asset liquidity risk associated with the potential need to liquidate the collateral assets posted to Acme Bank in case of a default event.
Answers here:
