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PART II - help with explaining the costs of an OTC derivative - Gregory, Ch 3.

kchristo

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In Gregory, Ch, 3, under the LOB Identify & explain the costs of an OTC derivative, Gregory seems to make some counterintuitive points. (page 10/11 in the study notes)

At the onset, I would imagine that a bank would hedge an OTC derivative with a hedge that would pay out when the bank has a negative MTM value for the OTC derivative and the hedge that require payment when the bank has a postiive MTM value. In Gregory's terms, this would mean that the hedge would pay out when the client has a positive MTM value and require payment when the client has a negative MTM value. Under such a hedge structure, the bank's hedge would offset the risk the bank has to pay when the client has a positive MTM value, and the hedge would also offset the receipt of payment when the OTC derivative pays out to the bank (or when the client is negative MTM). This is the opposite of what's said in the text. @David Harper CFA FRM can you please help me make sense of this seemingly backward logic?

Going off the first example in the study notes, if the client is positive MTM, then the bank owes the client. The bank wouldn't also want the hedge asset to be negative and have to pay out on both the hedge and OTC derivative with the client.
 
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