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David

Credit risk is defined as PD* LGD (in % terms) or PD*LGD*EAD in dollar terms.

Now when we hedge credit risk (CRM in Basel II lingo) which part of the equation are we actually mitigating? PD? LGD?

For example say that we have a exchange traded contract which requires daily MTM and margining. Now is this margining a hedge for PD or the LGD (assuming zero recovery)? My view is that the the margining is actually offsetting the LGD.

Similarly when you have a cash collateral (assume that the loan is collateralised 100%) then the collateral is strictly a hedge for the LGD. This is because you can't control PD (it is external) and hence you want to control LGD in order that the product (LGD*PD) is under control.

Let us take a example. Suppose we have PD= 3% and RR = 0% so that LGD = 100%. Now the credit risk for a $100 exposure is 3$. So should we be taking 3$ worth of collateral? No way!!

In practice we take collateral to cover the entire value of the exposure. So we take 100$ in cash, in which case it becomes LGD mitigation and not credit risk mitigation.

Is there some gap here in my thinking?

Jyothi

Credit risk is defined as PD* LGD (in % terms) or PD*LGD*EAD in dollar terms.

Now when we hedge credit risk (CRM in Basel II lingo) which part of the equation are we actually mitigating? PD? LGD?

For example say that we have a exchange traded contract which requires daily MTM and margining. Now is this margining a hedge for PD or the LGD (assuming zero recovery)? My view is that the the margining is actually offsetting the LGD.

Similarly when you have a cash collateral (assume that the loan is collateralised 100%) then the collateral is strictly a hedge for the LGD. This is because you can't control PD (it is external) and hence you want to control LGD in order that the product (LGD*PD) is under control.

Let us take a example. Suppose we have PD= 3% and RR = 0% so that LGD = 100%. Now the credit risk for a $100 exposure is 3$. So should we be taking 3$ worth of collateral? No way!!

In practice we take collateral to cover the entire value of the exposure. So we take 100$ in cash, in which case it becomes LGD mitigation and not credit risk mitigation.

Is there some gap here in my thinking?

Jyothi

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