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Learning objectives: Describe the rationale for collateral management. Describe the terms of a collateral and features of a credit support annex (CSA) within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount. Describe the role of a valuation agent.


905.1. Two counterparties (A and B, illustrated below) have between them a set of OTC derivative transactions.

Associated with the positions, these counterparties also entered into a bilateral collateral agreement prior to initiation of the underlying transactions. Each of the following is true EXCEPT which is false?

a. If they followed best practice, collateral posting should be continuous for both of them
b. As a counterparty risk mitigant, collateral posting is generally superior to a reset feature
c. Variation margin is a type of collateral that aims to track the change in valuation (aka, change in MTM) of the position over time
d. As a bilateral agreement, in the case of a positive MTM, the party will call for collateral; and in the case of negative MTM, the party will be required to themselves post collateral

905.2. Two counterparties are negotiating the terms of a new Master Agreement in reference to a series of derivative transactions. They are also negotiating the parameters of a credit support annex (CSA) which might be appended to the Master Agreement. There are three approaches: two-way CSA, one-way CSA, or no CSA.

About the possible CSA, which of the following statements is TRUE?

a. As CSAs are rare, the most likely approach is "No CSA"
b. If they agree to a one-way CSA, then by definition the CSA will specify a threshold of zero
c. If they agree to a two-way CSA, then either party can unilaterally edit the CSA subsequent to signing the CSA
d. If they agree to a one-way CSA, the non-collateral posting party is likely to pay charges for the counterparty risk (CVA), funding (FVA), collateral terms (ColVA) and/or capital requirements (KVA) they impose on the other party

905.3. As Jon Gregory says, "For centrally cleared transactions, collateral disputes are not problematic since the central counterparty is the valuation agent. However, central counterparties will clearly aim to ensure that their valuation methodologies are market standard, transparent and robust." However, it is not so simple in the over the counter (OTC) market: "Given the non-transparent and decentralized nature of the OTC market, significant disagreements can occur about collateral requirements." (Source: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital, 3rd edition (West Sussex, UK: John Wiley & Sons, 2015))

If a larger counterparty is trading with a smaller counterparty, supported by a collateral arrangement, in the OTC market, then which of the following is probably the most proactive solution with respect to the valuation agent?

a. Designate both parties as the valuation agent
b. Perform frequent (e.g., daily) reconciliations
c. Designate only the larger counterparty as the valuation agent
d. Designate only the smaller counterparty as the valuation agent

Answers here: