Outline how collateral operates in practice and the kinds of collateral commonly used.
The idea
In practice collateral works through a daily cycle. The valuation agent marks the portfolio and collateral to market, computes the call, and notifies the counterparty by the notification time. The transfer then settles the same or next business day. Cash is the most common collateral, typically in major currencies, with the receiver paying interest at an overnight rate. Government securities are also widely used, plus agency and high-grade corporate bonds, and occasionally equities, gold or letters of credit. Each non-cash asset carries a haircut that grows with price volatility, maturity and, for foreign-currency assets, an extra FX haircut. When several asset types are eligible, the pledgor tends to deliver the cheapest to deliver, which gives the secured party an embedded option. Remember that settlement delays and disputes lengthen the margin period of risk.
Formulas
Interest owed on cash collateral
Interest = C × r × d ÷ 360
- C
- the cash collateral held
- r
- the agreed overnight rate a year
- d
- the calendar days held
Actual/360, paid by the receiver to the poster. Dividing by 365 understates it.
Value of foreign-currency cash collateral
Collateral value = A × S × (1 − h)
- A
- the amount of foreign currency posted
- S
- the spot rate in base currency per unit of foreign currency
- h
- the FX haircut, as a decimal
Convert at spot, then apply the FX haircut that covers exchange-rate moves over the margin period of risk.
A practice question
Which pair of assets is most commonly accepted as collateral in OTC derivative CSAs?
- Direct holdings of real estate and private equity stakes in portfolio companiesWhy not: These are illiquid and hard to value daily, so they are rarely eligible.
- Cash in major currencies and top government bonds - correct
- Unrated corporate loans and trade receivablesWhy not: These are hard to value and liquidate quickly, which defeats the purpose.
- Commodity inventory held in the counterparty's own warehousesWhy not: These are illiquid and remain under the counterparty's control.
Collateral must be liquid, easy to value daily and stable in value; cash and top-quality government bonds fit best.
A harder one
A counterparty holds USD 10 million of cash collateral for 5 calendar days at an agreed overnight rate of 4.00% on an actual/360 basis. Interest owed to the poster is closest to:
- USD 5,479Why not: Uses actual/365 instead of the stated actual/360.
- USD 5,556 - correct
- USD 1,111Why not: Accrues for one day only instead of five.
- USD 7,778Why not: Counts a full calendar week instead of the 5 days stated.
Interest = 10,000,000 x 4.00% x 5 / 360 = USD 5,556.
The hardest tier
Which change would most likely lengthen the effective margin period of risk for a daily-margined portfolio?
- Moving from daily margining to intraday margining with same-day settlement of callsWhy not: Faster margining shortens the margin period of risk.
- Receiving cash rather than government bonds as collateralWhy not: Cash settles faster and is easier to realise, which does not lengthen the period.
- More frequent and longer disputes, and illiquid trades that are slow to replace - correct
- Reducing the threshold and minimum transfer amount to zeroWhy not: This reduces the amount left unsecured, not the time taken to close out.
The margin period of risk is a time span: disputes, settlement delays and illiquid trades extend it, while faster calls and settlement shorten it.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Margin (Collateral) and Settlement
- Outline why collateral is managed.
- Set out the terms found in a collateral agreement and the main features of a credit support annex (CSA) in an ISDA Master Agreement: credit support amount, credit quality, haircuts, rounding, minimum transfer amount, initial margin and threshold.
- Compute the margin, meaning the credit support amount, under a number of different scenarios.
- Outline what a valuation agent does.
- Account for how disputes over collateral are reconciled.
- Spell out what a collateralization agreement typically contains.
- Distinguish CSAs that run one way from those that run both ways, and describe how collateral parameters can depend on credit quality.
- Account for collateral-related aspects such as funding, rehypothecation and segregation.
- Show how collateralization can bring about market risk, operational risk and liquidity risk, funding liquidity risk included.
- Set out the assorted capital requirements imposed by regulators.