Learning Objectives: Define a central counterparty (CCP) and describe the mechanics of central clearing. Explain the concept of novation under central clearing. Define netting, multilateral offset, and compression and provide examples of each. Describe the application and estimation of margin and default funds under central clearing.
Questions:
24.29.1. Vintage Eagle Banking enters into an interest rate swap agreement with Vinyl Corporation through a central counterparty (CCP). The original swap contract has a notional value of $10 million and a maturity of 5 years. Vintage Eagle Banking agrees to pay a fixed rate of 2.5% and receive a floating rate based on the 3-month LIBOR. After novation, which of the following statements is TRUE?
a. The CCP has a total notional exposure of $20 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay Vintage Eagle Banking the floating rate and receive the fixed rate from Vinyl Corporation.
b. The CCP has a total notional exposure of $10 million, with $5 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the fixed rate to Vintage Eagle Banking and receive the floating rate from Vinyl Corporation.
c. The CCP has a total notional exposure of $10 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the floating rate to Vintage Eagle Banking and receive the fixed rate from Vinyl Corporation.
d. The CCP has a total notional exposure of $10 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the fixed rate to Vintage Eagle Banking and receive the floating rate from Vinyl Corporation.
24.29.2. GlobalClear, a central counterparty (CCP), clears interest rate swaps for its member banks. In a stress test, GlobalClear analyzed the impact of the default of its largest clearing member, Bank A, which has a notional exposure of $100 billion. The risk management team estimated the following:
a. Bank A will bear all losses, protecting other members.
b. Bank A's initial margin and default fund contributions absorb losses, reducing contagion.
c. GlobalClear's guarantee eliminates the need to replace defaulted swaps.
d. GlobalClear's risk management prevents Bank A's default altogether.
24.29.3. ClearX, a central counterparty (CCP), clears futures contracts on various commodities. The CCP has a total of 20 clearing members with varying degrees of risk exposure. ClearX's risk management team is reviewing its margin and default fund methodologies to ensure they are adequately calibrated to cover potential losses in extreme market conditions.
The team considers the following factors:
a. Increase the frequency of variation margin calls from daily to hourly to capture intraday price movements more effectively.
b. Allocate a larger portion of the default fund to the CCP's own capital contribution (skin-in-the-game) to align its interests with those of the clearing members.
c. Implement a more dynamic margin calculation model that incorporates market sentiment and news-based sentiment analysis, in addition to historical price data.
d. Conduct more extensive stress testing, considering a wider range of extreme but plausible market scenarios, and adjust margin and default fund requirements accordingly.
Answers here:
Questions:
24.29.1. Vintage Eagle Banking enters into an interest rate swap agreement with Vinyl Corporation through a central counterparty (CCP). The original swap contract has a notional value of $10 million and a maturity of 5 years. Vintage Eagle Banking agrees to pay a fixed rate of 2.5% and receive a floating rate based on the 3-month LIBOR. After novation, which of the following statements is TRUE?
a. The CCP has a total notional exposure of $20 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay Vintage Eagle Banking the floating rate and receive the fixed rate from Vinyl Corporation.
b. The CCP has a total notional exposure of $10 million, with $5 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the fixed rate to Vintage Eagle Banking and receive the floating rate from Vinyl Corporation.
c. The CCP has a total notional exposure of $10 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the floating rate to Vintage Eagle Banking and receive the fixed rate from Vinyl Corporation.
d. The CCP has a total notional exposure of $10 million, with $10 million each with Vintage Eagle Banking and Vinyl Corporation. The CCP will pay the fixed rate to Vintage Eagle Banking and receive the floating rate from Vinyl Corporation.
24.29.2. GlobalClear, a central counterparty (CCP), clears interest rate swaps for its member banks. In a stress test, GlobalClear analyzed the impact of the default of its largest clearing member, Bank A, which has a notional exposure of $100 billion. The risk management team estimated the following:
- Scenario 1: Replacing defaulted swaps would cost $2 billion.
- Scenario 2: Other members' defaults would lead to $5 billion in losses.
- Scenario 3: Bank A's initial margin and default fund contributions would be used, with remaining losses shared among surviving members, totaling $3 billion.
a. Bank A will bear all losses, protecting other members.
b. Bank A's initial margin and default fund contributions absorb losses, reducing contagion.
c. GlobalClear's guarantee eliminates the need to replace defaulted swaps.
d. GlobalClear's risk management prevents Bank A's default altogether.
24.29.3. ClearX, a central counterparty (CCP), clears futures contracts on various commodities. The CCP has a total of 20 clearing members with varying degrees of risk exposure. ClearX's risk management team is reviewing its margin and default fund methodologies to ensure they are adequately calibrated to cover potential losses in extreme market conditions.
The team considers the following factors:
- The historical price volatility of the cleared commodities
- The liquidity profile of the contracts
- The concentration of positions among clearing members
- Stress testing results based on historical and hypothetical market scenarios
- Regulatory guidelines for minimum margin and default fund requirements
a. Increase the frequency of variation margin calls from daily to hourly to capture intraday price movements more effectively.
b. Allocate a larger portion of the default fund to the CCP's own capital contribution (skin-in-the-game) to align its interests with those of the clearing members.
c. Implement a more dynamic margin calculation model that incorporates market sentiment and news-based sentiment analysis, in addition to historical price data.
d. Conduct more extensive stress testing, considering a wider range of extreme but plausible market scenarios, and adjust margin and default fund requirements accordingly.
Answers here:
