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P2.T6.904. Trade compression and termination events (Gregory Ch.5)

Nicole Seaman

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Learning objectives: Describe the effectiveness of netting in reducing credit exposure under various scenarios. Describe the mechanics of termination provisions and trade compressions and explain their advantages and disadvantages. Identify and describe termination events and discuss their potential effects on parties to a transaction.


904.1. According to Jon Gregory, netting is fairly common in the over the counter (OTC) derivatives market. Which of the following statements is TRUE about the impact of netting?

a. Netted positions are inherently more volatile than their underlying gross positions
b. Close-out netting reduces exposure in the OTC derivatives market by about 10.0%
c. Close-out netting is a risk mitigant but empirically has NOT proven to have a material effect on the OTC derivatives market
d. When a counterparty is in distress, the presence of netting tends to increase market participants' concerns, which in turn increases systematic risk

904.2. The graph below represents a trilateral scenario between three different counterparties (called A, B, and C) with position sizes in a certain fungible (aka, interchangeable) product. The values represent notional sizes and the direction represents exposures:

In this ring, the current total notional is 370. If trade compression can be achieved, which of the following is an efficient solution?

a. A -> 25 -> B -> 60 -> C (new total notional = 110)
b. A -> 30 -> B -> 45 -> C (new total notional = 150)
c. B -> 35 -> C -> 30 -> A (new total notional = 65)
d. B -> 25 -> C -> 10 -> A (new total notional = 70)

904.3. Doubledown Financial Corporation is going to enter a long-dated cross-currency swap with a counterparty and the parties are drafting the derivative contract's terms and conditions. Their contract will be governed by an ISDA Master Agreement. Doubledown's Board of Directors has emphasized three priorities with respect to the contract. First, they want to minimize their credit exposure if the position becomes deeply in-the-money. Second, they hope to avoid excessive modeling complexity. Third, they wish to minimize the contracts dependence on lagging indicators and to avoid so-called cliff-edge effects; this third preference is based on their memory of the lessons of the monoline insurer in the global financial crisis. Among the following termination features and resets, which is probably BEST suited to the Board's request?

a. Walkaway feature
b. Reset agreement
c. Break clause linked to credit rating downgrade
d. Additional termination event (ATE) linked to credit rating downgrade

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