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Show how collateralization can bring about market risk, operational risk and liquidity risk, funding liquidity risk included.

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

The idea

Collateralization swaps credit risk for other risks. Market risk: collateral securities can fall in value or be in a different currency, so a cushion of haircuts is needed, and on default the secured party faces price moves while it liquidates. Operational risk: margin calls, valuation, settlement, disputes, rehypothecation tracking and legal documentation all depend on people, systems and data, and errors create exposure or fails. Liquidity risk: variation margin calls demand cash or high-quality assets quickly, often when markets are stressed, which is funding liquidity risk. A hedger may pay out cash on a derivative while the offsetting gain on the hedged item is not yet realized. Rating-triggered calls and forced asset sales can reinforce each other in a liquidity spiral. The point: collateral reduces credit risk at a cost elsewhere.

Formulas

Market risk of holding collateral through liquidation

Collateral VaR = z × σ × V × √T

z
the standard normal quantile for the confidence level, 2.326 at 99%
σ
the daily return volatility of the collateral, as a decimal
V
the market value of the collateral
T
the days needed to liquidate after default

Assumes normal, independent daily returns. Haircuts should cover this move; scaling by T rather than √T overstates it.

Collateral shortfall after a price fall

Shortfall = E − MV × (1 − h)

E
the exposure the collateral secures
MV
the collateral's market value after the price change
h
the haircut, as a decimal

Apply the price fall to market value first, then the haircut. A negative result is surplus collateral.

A practice question

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

Why does variation margining give rise to liquidity risk for the pledgor?

  1. Margin is called only in the pledgor's own currency, so there is no funding needWhy not: Calls require funding in whatever currency or assets are eligible, so a need always exists.
  2. Margin calls reduce the pledgor's exposure to zero, so it needs less liquidityWhy not: Margin lowers credit exposure but creates cash needs; it does not reduce the pledgor's liquidity needs.
  3. Collateral has no market value, so the pledgor cannot raise it when a call arrivesWhy not: Collateral has market value; the problem is raising it quickly.
  4. Margin calls require cash or eligible assets at short notice, hard to raise in a stressed market - correct

Variation margin is paid in cash or high-quality assets quickly, so a loss-making position triggers an immediate funding need.

A harder one

A commodity producer sells forward its output through a collateralised swap. Prices rise and it faces large variation margin calls, while the gain on its unsold inventory is not yet realised. Which risk is most directly created?

  1. Credit risk, because the loss on the swap is large enough to make the producer default on its obligationsWhy not: The producer has not defaulted; the issue is the need to pay cash margin.
  2. No risk, since margin is paid only at maturityWhy not: Variation margin is paid as values move, not at maturity.
  3. Funding liquidity risk, because margin is paid in cash now while the offsetting gain is not yet received - correct
  4. Market risk, because the hedge has failed to offset its exposure to the commodity priceWhy not: The hedge works economically; the problem is timing of cash.

The economic position is hedged, but margin forces cash out before the offsetting gain is realised, a funding liquidity strain.

The hardest tier

A leveraged fund meets rising variation margin calls by selling the assets it holds, which pushes prices down and triggers further calls. This best illustrates:

  1. Wrong-way credit risk from collateral posted in the counterparty's own securitiesWhy not: Wrong-way risk concerns correlation of exposure with counterparty credit quality, not forced selling.
  2. A liquidity spiral linking funding liquidity risk and market liquidity risk - correct
  3. Settlement risk arising from non-simultaneous paymentsWhy not: Settlement risk concerns payments not made together, not price feedback.
  4. Operational risk arising from a failed margin settlementWhy not: Calls are met and settled; the problem is the sales that follow.

Calls force sales, sales depress prices, and lower prices cause more calls, so funding and market liquidity risk reinforce each other.

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