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P1.T3.602. Over the counter (OTC) derivatives (Gregory)

Nicole Seaman

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Learning objectives: Identify the classes of derivatives securities and explain the risk associated with them. Identify risks associated with OTC markets and explain how these risks can be mitigated.

Questions:

602.1. Which OTC derivatives class has the largest amount of gross notional outstanding?

a. Equity derivatives
b. Credit default swaps
c. Interest rate derivatives
d. Foreign exchange derivatives


602.2. Among the following, what is the most common method for quantifying counterparty risk into the price of a transaction?

a. Novation
b. Vertical setup
c. Trade compression
d. Credit value adjustment (CVA)


602.3. In regard to lessons of the global financial crisis (GFC), Gregory writes, "The OTC derivative market developed other mechanisms [i.e., in addition to netting and margin requirements] for potentially controlling the inherent counterparty and systemic risks they create. Examples of these mechanisms are SPVs, DPCs, monolines and CDPCs. Although these methods have been largely deemed irrelevant in today’s market, they share some common features with CCPs and a historical overview of their development is therefore useful ... The concepts of SPVs, DPCs, monolines and CDPCs have all been shown to lead to certain issues. Indeed, it could be argued that as risk mitigation methods they all have fatal flaws, which explains why there is little evidence of them in today’s OTC derivative market. It is important to ask to what extent such flaws may also exist within an OTC CCP, which does share certain characteristics of these structures." (Source: John Gregory, Central Counterparties: Mandatory Clearing and Bilateral Margin Requirements for OTC Derivatives (New York: John Wiley & Sons, 2014))

In regard to the lessons of the crisis and these mechanisms--i.e., SPV, monolines and CDPC--each of the following statements is true EXCEPT which is false?

a. A special purpose vehicle (SPV) transforms counterparty risk into legal risk
b. A key difference between CCPs and monolines/CDPCs is that CCPs require initial and variation margin in all situations
c. A central counterparty (CCP) would almost certainly have prevented AIG by clearing their trades and disbelieving their inflated AAA ratings
d. A key difference between CCPs and monolines/CDPCs is that CCPs have a "matched book" and do not take any residual market risk (except when members default

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