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Outline how collateral operates in practice and the kinds of collateral commonly used.

FRM® Part II · Credit Risk Measurement and Management · Margin (Collateral) and Settlement · FRM2.CR.17.e

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

From the question bank, with the reason each wrong option is wrong.

Which pair of assets is most commonly accepted as collateral in OTC derivative CSAs?

  1. 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.
  2. Cash in major currencies and top government bonds - correct
  3. Unrated corporate loans and trade receivablesWhy not: These are hard to value and liquidate quickly, which defeats the purpose.
  4. 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:

  1. USD 5,479Why not: Uses actual/365 instead of the stated actual/360.
  2. USD 5,556 - correct
  3. USD 1,111Why not: Accrues for one day only instead of five.
  4. 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?

  1. Moving from daily margining to intraday margining with same-day settlement of callsWhy not: Faster margining shortens the margin period of risk.
  2. Receiving cash rather than government bonds as collateralWhy not: Cash settles faster and is easier to realise, which does not lengthen the period.
  3. More frequent and longer disputes, and illiquid trades that are slow to replace - correct
  4. 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.

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