2105frm一级基础金融市场与产品电子阅读版

TopicWeightingsinFRMPartⅠ

SessionNO.

Content

Weightings

StudySession1

FoundationsofRiskManagement

20

StudySession2

QuantitativeAnalysis

20

StudySession3

FinancialMarketsandProducts

30

StudySession4

ValuationandRiskModels

30

Framework

BondMarket

InterestRates

TreasuryMarketandCorporateBond

DerivativesMarket

IntroductionofDerivativesMarket

ForwardandFutures

Swaps

OptionsMarkets

MBS

FinancialInstitutions

Bank

Insurance

FundManagement

BondMarket

Topic1:InterestRates

MarketRate

Compounding

SpotRateandForwardRate

TermStructure

TreasuryRates

TheratesaninvestorearnsonTreasurybillsandTreasurybonds.

Treasuryratesarerisk-freeratesinthesensethatitisconsideredhighlyunlikelythatthegovernmentofadevelopedcountrywilldefaultondebtissuedinitsowncurrency。

LIBOR

LIBORarecompiledfromtheestimatedunsecuredborrowingcostsof18highlyratedglobalbanks.

SOFR

ThereareplanstobeginphasingoutLiborandreplaceitwitharatebasedonactualtransactions。U.S.hasproposedtheuseoftherepo-basedSecuredOvernightFinancingRate(SOFR)

RepoRates

Inarepurchaseagreement,thedifferencebetweensellingprice(today)andtherepurchasedprice(tomorroworlater)iscalledthereporate.

Risk-FreeRate

Therisk-freerateatwhichderivativesarepricedisdeterminedfromovernightinterbankratesusingovernightindexedswaps.TheTreasuryrateisusuallynotadopted,becauseitisusuallyartificiallylow,mainlyduetothefollowingtworeasons:

RegulationgenerallydoesnotrequireBankstoretaincapitalfortheirTreasurypositions.

Insomecountries(suchastheUnitedStates),Treasuryyieldsgetpreferentialtaxtreatment.

Compounding

CompoundingFrequencies

Supposewehaveanaccountwherethesimpleinterestisaddedineachyearandthenthatmoneyalsoearnsinterest.

Assuming

RCistherateofinterestwithcontinuouscompounding.

Rmistherateofinterestwithdiscretecompounding(mperannum)

Tisthenumberofyears.

FV=PV 1+m

PV 1+R1

=PV 1+R2

SpotRate

At-periodspotrate,orzerorate,istheinterestrateearnedwhencashisreceivedatjustonefuturetime.

DeterminingZeroRateswithBootstrapMethod

Workingforwardandfittingthezeroratestoprogressivelylongermaturityinstruments.Theothercouponscanbedeterminedbyinterpolationfromtheratesthathavealreadybeendetermined.

Example:Giventhe0.5,1.0and1.5yearszerorateare2.0%,2.3%,2.5%respectively,the2yearzerorateofa2yearbondwithaparvalueof

$100andamarketvalueof$98.82whichpays(semi-annual)couponattherateof2%peryearcanbecalculatedasfollows:

1

+

1+0.02/2

1 1 101

1+0.023/2

1+R/2

+ + =98.82

Forwardrates

1+R1

1+F

1+R2

=eR2T2→F=R2T2−R1T1

T2−T1

Interestratescorrespondingtoafutureperiodimpliedbythespotcurve.

ParRate

Let'ssaythereisabondwithamaturityofTyears.Whenthecouponis0,thisisazerocouponbond.Thisbondisissuedatadiscount.Ifthecouponrategoesup,thevalueofthebondgoesup.Andwhenthecouponrateisatsomeparticularvalue,thevalueofthebondisexactlyequaltotheparvalue,whichiscalledtheparrate.

SpotRatesandForwardRates

Maturity(year)

SpotRate

ForwardRate

0.5

0.94%

0.94%

1

1.37%

1.79%

1.5

1.82%

2.73%

2

2.51%

4.58%

2.5

3.08%

5.37%

3

3.87%

7.87%

9.00%

8.00%

Forwardrate

7.00%

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

0.5 1 1.5 2 2.5 3

Maturity(year)

1+

0.94%

2

1+

2

F0.5,1

2

1.37%

2

= 1+

F0.5,1=1.79%

MajorTheoriesoftheTermStructureofInterestRates

ExpectationsTheory

Expectationstheoryarguesthattheinterestratetermstructurereflectswherethemarketisexpectinginterestratestobeinthefuture.

Ifthemarketexpectsinterestratestorise,thetermstructurewillbeupward-sloping,thatis,long-maturityratesbeinghigherthanshort-maturityinterestrates.

Ifthemarketexpectsinterestratestodecline,thenthetermstructurewillbedownward-sloping,thatis,long-maturityratesbeinglowerthanshort-maturityrates.

Inreality,theexpectationstheoryfailstoexplainwhytheinterestrate

curveisusuallyupwardsloping.

MajorTheoriesoftheTermStructureofInterestRates

MarketSegmentationTheory

Thebondmarketissegmentedintodifferentmaturitysectors;supplyanddemanddeterminethebondpricesorinterestrates.

LiquidityPreferenceTheory

Liquiditypreferencetheoryarguesthatmostentitiesliketoborrowlongandlendshort.Thistheoryisconsistentwiththeempiricalresultthatyieldcurvestendtobeupwardslopingmoreoftenthandownwardsloping.

Abankusesacontinuously-compoundedannualinterestrateof5%inoneofitsriskmodels.Whatistheequivalentinterestratethebankshoulduseifitconvertstosemi-annualcompoundinginthemodel?

4.94%

5%

5.06%

5.12%

CorrectAnswer:C

Assumethatthecontinuouslycompounded10-yearspotrateis5%andthe9-yearspotrateis4.9%.Whichofthefollowingisclosesttothe1-yearforwardratenineyearsfromnow?

4.1%.

5.1%.

5.9%.

6.0%.

CorrectAnswer:C

BondMarket

Topic2:TreasuryMarket

IntroductionofBondMarkets

TreasuryInstruments

Whatisabond?

Issuer/Borrower

Bonds

Indenture Bondholder/Lender/Investor

Money

CharacteristicsofBonds

CouponRate

FaceValue

Maturity

YieldtoMaturity(YTM)

AnnuityandPerpetualBond

Howtodeterminethepriceofabond?

Principle

P= C1 C2 +⋯+ CT

T

=� Ct

+

1+y (1+y)2

(1+y)T

(1+y)t

t=1

WhereCt=thecashflow(couponorprincipal)inperiodt

t=numberofperiodstoeachpayment(e.g.,halfyears;aquarteryears)

T=thenumberofperiodstomaturity

y=thediscountingrateperperiod

TreasuryBills

Ashort-termdebtobligationwithamaturityofoneyearorless.

Interestrateisexpressedonadiscountbasis.

TreasuryNotesandTreasuryBonds

Bondwithamaturityofmorethanoneyear.BondswhichtypicallyhavematuritiesbetweenonetotenyearsarecalledTreasuryNotes.Buttokeeptheterminologysimple,wewillrefertoallcoupon-bearingTreasuryinstrumentsasTreasuryBonds.

Bothmakeinterestpaymentssemi-annually.

QuotedPrice：

Dollarsandthirty-secondsofadollarwithfacevalueof$100

TreasurySTRIPS

C-StripsandP-Strips

CleanPriceandDirtyPrice

CleanPrice

Thepriceofacouponbondnotincludinganyaccruedinterest.Immediatelyfollowingeachcouponpayment,thecleanpricewillequalthedirtyprice.

DirtyPrice

Abondpricingquotereferringtothepriceofacouponbondthatincludesthepresentvalueofallfuturecashflows,includinginterestaccruingonthenextcouponpayment.

dirtyprice=cleanprice+accruedinterest

AccruedInterestandDayCountConventions

Treasurybonds:actual/actual

Corporateandmunicipalbonds:30/360

Moneymarketinstruments(Treasurybills):actual/360

Example

Supposea1000parvalueUScorporatebondpaysasemi-annual10percentcoupononJanuary1andJuly1.AssumethatitisnowApril1,2005,andthebondmaturesonJuly1,2015.Computetheinvoice(full)priceofthisbondiftherequiredannualyieldis8percent.Computetheflat(clean)priceoftheabovebond.

Time

Mar1st

Apr1st

May1st

June1st

July1st

dirtyprice

1155.30

1162.87

1170.50

1178.18

1185.90

cleanprice

1138.63

1137.87

1137.17

1136.51

1135.90

Exercise1

Assumeacorporatebondwithafacevalueof$1,000thatpaysasemi-annualcoupon(couponspayJanuaryandJuly1st)witha12.0%couponrate.ThebondsettlesonJune13th,2014andmatures,more

thansixyearslater,onJuly1st,2020.Atthecurrenttradedprice,thebond'syield(YTM)is10.0%.Whichisnearesttothebond'squoted(aka,clean)price?

$975

$1,089

$1,107

$1,143

CorrectAnswer:B

BondMarket

Topic3:CorporateBond

BondTrading

BondIndentures

ClassificationofBonds

BondRisk

DebtRetirement

BondTrading

TradingCharacteristic

BondsIssuedviaPrivatePlacements

Heldbytheoriginalpurchasersuntilmaturity.

Areoftennottraded.

BondIssuedinaPublicOffering

Typicallytradedintheover-the-countermarket.

BondYield

Thereturnearnedonabondoveritslifetimeassumingallinterestandprincipalarepaidaspromised.

Composedofarisk-freereturnandacreditspread.

Partoftheyieldmaybecompensationforliquidityrisk.Asliquiditydeclines,investorsrequireagreateryield.

BondIndentures

BondIndenture

Contractcontainscorporatebondissuerpromisesandinvestors’rights.

Madeouttocorporatetrustee,whorepresentsbondholders’interests.

CorporateTrustee

Afinancialinstitutionthatlooksaftertheinterestsofthebondholdersandensuresthattheissuercomplieswiththeindentures.

Itsdutiesarespecifiedintheindenturesandthetrusteeisundernoobligationtoexceedthoseduties.

Forexample,sometimestheindenturespecifiedthattrusteecanrelyontheissuerforinformation,sothat,itisnotrequiredtoconductitsowninvestigations.

InterestRate

Fixed-RateBonds

Floating-RateBonds

Zero-CouponBonds

IntheUnitedStates,holdersofcoupon-bearingbondscanclaimtheprincipalintheeventoftheissuer'sbankruptcy,whereasholdersofzero-couponbondscanclaimtheinitialpurchasepriceplusaccruedinterest.

Collateral

MortgageBonds

CollateralTrustBonds

EquipmentTrustCertificates

DebentureBonds(includingSubordinatedDebentures)

GuaranteedBonds

High-YieldBond

High-yieldbondsarethoseratedbelowinvestmentgradebytheratingsagencies,theseissuesarealsoknownasjunkbonds.

TypesofHigh-YieldBondIssuers

OriginalIssuers

FallenAngels

RestructuringsandLeverageBuyouts

PaymentFeatures

Deferred-InterestBonds

Step-UpBonds

Payment-in-Kind(PIK)Bonds

ExtendableResetBonds

BondRisk

EventRisk

Therearemanyeventsinthemarketthatcanadverselyaffectbonds,suchasnaturaldisasters.Thistypeofriskiscalledeventrisk.Oneimportanttypeofeventriskistheriskofalargeincreaseinleverage.

CreditRisk

CreditDefaultRisk:Riskthatabondissuerwillbeunabletomeetitsfinancialobligations.

CreditSpreadRisk:Riskoffinanciallossresultingfromchangesinthelevelofcreditspreads.

RiskMetrics

IssuerDefaultRatevs.DollarDefaultRate

RecoveryRate

ExpectedReturn:Risk−FreeRate+CreditSpread−ExpectedLossRate

DebtRetirement

CorporateBondRetirements

Frequently,bondsareretiredearly,beforematurity.Thereareseveralmechanismsbywhichacorporationmaygoaboutretiringtheirdebt:

Callprovision

Sinking-fundprovisions

Maintenanceandreplacementfunds

Tenderoffers

Aportfoliomanagerhasrecentlypurchaseda10-yearinvestment-gradecorporatebond.Whichofthefollowingtasksmusttypicallybeperformedbythecorporatetrusteelistedinthebond’sindenture?

Actinafiduciarycapacityforthebondissuer.

Ensurethatthebondissuer’sreportedfinancialratiosmeettherequirementsintheindenture.

Changethetermsoftheindenturetoprovideprotectionforthebondpurchaser.

Monitor the bond issuer’s balance sheet to ensure covenantcompliance.

CorrectAnswer:B

Whichbondinstrumentswouldhavethelowestrisk, asotherthingsbeingequal?

Juniortranches.

Equitytranches.

ETCs.

Debentures.

CorrectAnswer:C

Derivatives Market

Topic1:IntroductionofDerivativesMarket

IntroductionofDerivatives

BroadCategoriesofTraders

OTCandExchangeMarket

CentralCounterparty

Derivatives

Aninstrumentwhosevaluedependsonthevaluesofothermorebasicunderlyingassets.

BasicTypesofDerivatives

ForwardandFutures

Agreementtobuy/sellassetatfuturetimeforcertainprice.

Forward:tradedintheover-the-counter(OTC)market.

Futures:Standardizedandtradesonanexchange.

Swap

Aseriesofforwardcontracts.

Exchangecashflowsonperiodsettlementdates.

Option

Givesholdertheright(butnotobligation)tobuy/sellatacertainprice.

LinearandNon-LinearDerivatives

Derivativescanbedividedintolinearandnonlinearcategories.

Thepayoffoflinearderivativesislinearlyrelatedtothevalueoftheunderlyingassets.Forexample,forwardcontractsarelinearderivatives.

Options,ontheotherhand,arenonlinearderivatives,thatis,thereisanon-linearrelationshipbetweenthepayoffoftheoptionandthevalueoftheunderlyingasset.

DerivativesRisks

Speculatorscanobtainleverageinderivativestrading,whichmeanstradersarevulnerabletosignificantrisks.

Andtherewardsforsuccessfulspeculationaresohighthatmanytradersaretemptedtostartspeculating,eveniftheystartedouthedgingorlookingforarbitrageopportunities.Ifcontrolsarenotinplace,thesetradersmaystartspeculatingwithouttheknowledgeofothersintheorganization.

Inaddition,whenspeculativetraderslosemoney,theymayseektooffsettheirlossesbytakingincreasinglylargeandriskypositions.Ifoffsetgainsdonotmaterialize,tradersmayincreasetheirriskuntillossesreachcatastrophiclevels.

BroadCategoriesofTraders

Hedgers

Usederivativesmarketstooffsettheriskofpricesmovingunfavorablyfortheirongoingbusinessactivities.

Speculators

Usederivativestoseekprofitsbybettingonthefuturedirectionofmarketpricesoftheunderlyingasset.

Arbitrageurs

Usederivativestotakeoffsettingpositionsintwoormoreinstrumentstolockinaprofit.

MarketMaker

Amarketmakerisafirmfacilitatethetradingofaparticularsecuritytokeepthefinancialmarketliquidbyprovidingbuyandsellquotationssimultaneously.

Over-the-CounterandExchangeTraded

Over-the-Counter

Exchange-Traded

Customized

Standardized

Tradewithcounterparty(DefaultRisk)

Backedbyaclearinghouse

Nottradeinacentrallocation

Tradeinaphysicalexchange

Unregulated

Regulated

Tradingvolume:large

Tradingvolume:small

ExchangeMarket

Anexchangemarketisamarketwhereinvestorstradestandardizedcontractsmadebyexchanges.

Today,exchangesclearalltradesbetweenmembersthroughso-called

centralcounterparties(CCPs).

Exchanges(throughtheirCCPS)actascounterpartiestoallmembers.

AnotheradvantageofusingaCCPisthatitiseasierforexchangememberstocloseoutpositions.

Anothermeasuretoprotectmembersfromlossesisnetting.Nettingisanoperationinwhichshortandlongpositionsinaparticularcontractcanoffseteachother.

ExchangeMarket

Theexchangerequiresmemberstoprotectthemselvesbyprovidingmargin.Marginreferstothecashorassetstransferredfromonetradertoanotherforprotectionagainstcounterpartydefault.

VariationMargin

InitialMargin

Inaddition,membersarerequiredtosubmitadefaultfundasalossprotection.

Iftheinitialmarginisnotsufficienttocoveramember'slossesduringadefault,themember'sdefaultfundcontributionswillbeusedtocoverthedifference.Ifthesefundsremaininsufficient,theyarereplenishedbythedefaultfundsofothermembers.

VariationMargin

Tradesmadeonanexchangearenotsettledatmaturity.Instead,itmarkstomarketdaybyday.

Eachday,thelosingmemberpaystheexchangeCCPanamountequaltotheloss,whiletheprofitablememberreceivesanamountequaltothegainfromtheexchangeCCP.Thesepaymentsarecalledvariationmarginandusuallyoccurdaily.

Markingtomarkethasanotherimportantbenefit:itmakesclosingoutcontractseasier.

Example

ConsiderTraderXwhoislongthreeJunecorncontracts(contractstobuy15,000bushelsofcorninJune).SupposethattheJunefuturespriceis500centsperbushelatthecloseoftradingonDay1and490centsperbushelatthecloseofDay2.TraderXhaslost

15,000×10cents

orUSD1,500.ThisisbecauseJunecornisnowworthtencentslessperbushelthanitwasworthatthecloseoftradingonDay1.ThetraderisthusrequiredtopayUSD1,500totheCCP.IfJunecornis495centsperbushelatthecloseofDay3,TraderXhasgained

15,000×5cents

orUSD750.Inthiscase,theexchangepaysthetraderUSD750.

InitialMargin

Theinitialmarginisusuallysetbytheexchangeandisbasedonpricevolatility.

Becausecontractsaremarkedtomarketdaybyday,CCPsdonotpayinterestonvariationmargin.However,CCPswillpayinterestontheinitialmarginbecauseitbelongstothememberpayingthemargin.IftheratepaidbytheCCPisnotsatisfactory,membersmayreplacecashdepositswithsecuritiessuchasTreasurybills.Inthatcase,theCCPwouldreducethevalueofthesecuritiesbyacertainpercentagewhendeterminingtheircashmarginequivalents.Thisreductioniscalledahaircut.

MaintenanceMargin

Sofar,we'vebeentalkingaboutmarginaccountsbetweenCCPsandtheirmembers.However,ifaretailtradercontactsabrokertotrade,thattraderwillberequiredtoprovidemargintothebroker.

MarginaccountsbetweenretailtradersandbrokersdifferfromthosebetweenCCPsandtheirmembers.Itgenerallycontainsprovisionsformaintenancemargin.Inaccordancewiththegeneralrulesofmaintenancemargin,ifthebalanceofthemarginaccountfallsbelowthemaintenancemarginlevel,thetradermustprovideadditionalmargintorestoretheaccounttotheinitialmarginlevel.Ifthetraderdoesnotprovideadditionalmargin,thebrokerentersareversetradeonbehalfofthetradertocloseouttheposition.

Example

ContractSpecifications

ContractSize(ounces)

100

NumberofContracts

2

InitialFutures

$600

Margin

Per

Total

Initialmargin

$2,000

$4,000

Maintenancemargin

$1,500

$3,000

OTCMarket

AnOTCmarketisamarketinwhichparticipantsdirectlycontacteachother(orpossiblybyusingabrokerasanintermediary)totrade.

OTCmarketparticipantscanbedividedintoendusersanddealers.End-usersincludecompanies,fundmanagersandotherfinancialinstitutionsthatusederivativestomanageriskorgainspecificexposures.Dealersarelargefinancialinstitutionsthatprovidebidandaskquotesforcommonderivativestrades.

InterestratederivativesarethemostpopularderivativesintheOTCmarket.Mostinterestratederivativesareinterestrateswaps.

OTCMarket

TheattractionoftheOTCmarketisthatderivativesdonotneedtobestandardized,sotheycanbetailoredtotheneedsoftheenduser.However,oneofthemaindisadvantagesisthecounterpartyrisk.

IntheOTCmarketwithbilateralclearing,creditriskmanagementcanbecarriedoutbycallingforcollateral.Thecreditsupportannex(CSA)ofthemasteragreementbetweenthepartiesspecifieshowtocalculatethecollateralrequiredandwhatsecuritiescanbepostedascollateral.

TraditionalOTCderivativestradesarebilaterallycleared.Thisinvolvesthepartiesagreeingonhowtoclear,whatnettingarrangementswillbeusedandwhatcollateral,ifany,willbeposted.However,CCPshavebeenaroundforsometimeinOTCmarketsandhavebeenincreasinglyusedinthewakeofthe2007-2008globalfinancialcrisis.

OTCMarket

Beforethe2007-08creditcrisis,over-the-countermarketswerelargelyunregulated.Severalnewruleshavebeenintroducedsincethefinancialcrisis.Herearesomeimportantrules:

IntheUS,standardizedOTCderivativestradedbetweendealersmustbetradedonswapexecutionfacilities.Thisissimilartoexchangesormarketparticipantswhopublishbidandaskprices.

Centralcounterparties(CCPS)mustbeusedforstandardizedtradingbetweendealers.

Alltransactionsmustbereportedtoacentralregistry.

OTCMarket

ASpecialPurposeVehicle(SPV),alsoknownasaSpecialPurposeEntity(SPE),isacompanyestablishedbyanothercompanyandthecreditriskofthetwocompaniesislegallyseparate.

SPVsandSPEsareoftenusedtoconstructderivativesbasedonportfoliosofassets,suchasmortgagesorothertypesofloans.

Forexample,supposecompanyXcreatesSPV/SPEcompanyY.Typically,XtransfersassetstoYandnolongercontrolsthem.IfXgoesbankrupt,Ycancontinuetomeetitsobligations(andviceversa).

Whichoneofthefollowingstatementsisincorrectregardingthemarginingofexchange-tradedfuturescontracts?

Daytradesandspreadtransactionsrequirelowermarginlevels.

Ifaninvestorfailstodepositvariationmargininatimelymannerthepositionsmaybeliquidatedbythecarryingbroker.

Initialmarginistheamountofmoneythatmustbedepositedwhenafuturescontractisopened.

Amargincallwillbeissuedonlyiftheinvestor’smarginaccountbalancebecomesnegative.

CorrectAnswer:D

Atraderbuysonewheatcontract(underlying=5,000bushels)atapriceof$3.05perbushel.Theinitialmarginonthecontractis$4,500andthemaintenancemarginis$3,750.Atwhatpricewillthetraderreceiveamaintenancemargincall?

$2.30

$2.90

$3.20

$3.80

CorrectAnswer:B

Toutilizethecashpositionofassetsundermanagement,aportfoliomanagerentersintoalongfuturespositionontheS&P500indexwithamultiplierof250.Thecashpositionis$15millionwhichatthecurrentfuturesvalueof1,000,requiresthemanagertobelong60contracts.Ifthecurrentinitialmarginis$12,500percontract,andthecurrentmaintenancemarginis$10,000percontract,whatvariationmargindoestheportfoliomanagerhavetoadvanceifthefuturescontractvaluefallsto995attheendofthefirstdayofthepositionbeingplaced?

$30,000

$0

$300,000

$75,000

CorrectAnswer:B

Date

DecemberS&P500Futuresprice

DailyGain/Loss(USD)

9/10

1,734

-

9/11

1,756

550,000

9/12

1,712

-1,100,000

9/13

1,698

-350,000

OnSeptember10,atraderopensalongpositionin100DecemberS&P500futurescontracts.TheinitialmarginrequirementisUSD2million,andCMErequiresamaintenancemarginofUSD1.5million.AssumethatthepositioniskeptopenuntilSeptember14andnowithdrawalstakeplace.Thefollowingtablesummarizesthedailychangeinvalueofthepositionforthatperiod:

Onwhatdateswilladditionalmarginberequired?

September12,butnotSeptember13

September13,butnotSeptember12

September12andSeptember13

NeitherSeptember12norSeptember13

CorrectAnswer:A

Introduction

ThischapterfocusesonCCPsinOTCmarkets.TheseCCPsoperatesimilartothoseusedbyexchanges.LikeexchangeCCPs,membersofOTCCCPsmustprovideinitialmarginandvariationmarginandmakecontributionstothedefaultfund.

However,productsbeingclearedintheOTCmarketdifferfromthosebeingclearedbyexchanges.AnotherkeydifferenceisthatOTCcontractsarelessliquidthanexchange-tradedcontracts.Thesedifferencesalsoaffectthecalculationofvariationmargin.WhendeterminingmarginrequirementsforOTCmarkets,amodelisusuallyused.

OperationofCCPs

Variablemarginpaymentsaremadedailytoreflectchangesinthevalueofeachmember'sportfolio.

Theinitialmargintobepaidbyeachmemberiscalculatedusinghistoricaldata.However,ifthedefaultmember'sinitialmarginisinsufficienttocovertheloss,thedefaultfundofthedefaultmemberneedstobeusedtoreplenish.Ifthatisnotenough,thecontributionsfromothermembersareused.

Whenamemberdefaults,theexchangeusuallyholdsanauction,invitingothermemberstobidforthetransaction.

CCPsmaychoosetotearupdeals.Thisinvolvestheimmediatecloseoutoftransactionsbetweenamemberandthedefaultingpartyatapricethatcausessomelosstothenon-defaultingparty.

RegulationofOTCDerivativesMarket

RegulationsintroducedsincetheglobalfinancialcrisishaveledtoanincreaseintheuseofCCPsintheOTCderivativesmarket.TherulesstemfromthebeliefthatcomplexOTCderivatives,particularlythosederivedfromsubprimemortgageportfolios,playedaroleintriggeringthecrisis.

WhenG-20leadersmetinPittsburghinSeptember2009,theywereparticularlyconcernedaboutsystemicrisk.TheirstatementafterthePittsburghsummitincludedthefollowingparagraphs:

AllstandardizedOTCderivativescontractsshouldbetradedontheappropriateexchangeorelectronictradingplatformandclearedthroughthecentralcounterpartybytheendof2012atthelatest.OTCderivativescontractsshouldbereportedtothetraderepositories.Noncentrallyclearedcontractsshouldmeethighercapitalrequirements.

RegulationofOTCDerivativesMarket

TheG-20meetinginPittsburghproducedthreemajorregulationsaffectingOTCderivatives.

RequireallstandardizedOTCderivativestobeclearedthroughCCPs.Standardizedderivativesincludestandardinterestrateswapsandcreditdefaultswapsonindices.Theaimistocreateanenvironmentinwhichtradershavelesscreditexposuretoeachother,reducinginterconnectednessandsystemicrisk.

RequirestandardizedOTCderivativesbetradedonelectronicplatformstoimprovepricetransparency.

RequirealltransactionsintheOTCmarkettobereportedtothecentraltraderepository.TherequirementprovidesregulatorswithimportantinformationabouttheriskstakenbyOTCmarket.

Contrast:MarginRequirementsinBilateralMarkets

Thenewrules,whicharebeingphasedinbetween2016and2020,requiremargintobepostedforunclearedderivativestradedbetweentwofinancialinstitutions,orbetweenafinancialinstitutionandasystemicallyimportantnon-financialinstitution.Underthenewrules,initialmarginandvariationmarginmustbesubmitted.

Variationmargininunclearedtradesisusuallypasseddirectlyfromonecounterpartytoanother.However,regulationsrequirethattheinitialmarginforunclearedtransactionsbetransferredtoathirdpartytobeheldintrust.

AdvantagesandDisadvantagesofCCPs

AdvantagesofOTCCentralClearing

Easyexit

Lossmutualization

Standard loss management mechanism (margin, netting, defaultresolution)

Increasedliquidity

FormulationofstandarddocumentsforOTCderivativestransactions.

DisadvantagesofOTCCentralClearing

Moralhazard

Adverseselection

Procyclicality

Creditriskfacedbymembersbasedondefaultfundscontribution

CCPRisks

DefaultRisk

Defaultofaclearingmemberand,moreimportantly,thepossibleassociatedorknock-oneffectsthatthiscouldcause.

Aftermathofadefaulteventcreatefurtherproblems:Defaultordistressofotherclearingmembers;Failedauctions;Resignations;Reputational.

LiquidityRisk

ACCPfacesliquidityriskduetothelargequantitiesofcashthatflowthroughthemduetovariationmarginpaymentsandothercashflows.

Intheeventofadefault,theCCPmustcontinuetofulfilitsobligationstosurvivingmembersinatimelymanner.

CCPRisks

ModelRisk

Valuationmodelsarerequiredtomark-to-marketproductsforvariationmarginpurposes.Theapproachesforma