Financial Risk Manager Part 2
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A junior risk analyst at a consulting firm is analyzing the operational structures of bilateral netting versus central clearing when handling derivative trades. In the process, the analyst investigates the following bilateral trade exposures among three firms:
Firm 1's exposure to Firm 2: AUD 90 million
Firm 2's exposure to Firm 1: AUD 60 million
Firm 1's exposure to Firm 3: AUD 12 million
Firm 3's exposure to Firm 1: AUD 70 million
Firm 2's exposure to Firm 3: AUD 57 million
Firm 3's exposure to Firm 2: AUD 0 million
Evaluate the accuracy of the following statement:
| Party | No Netting | Bilateral Netting | Central Clearing |
|---|---|---|---|
| Firm 1 | 90 + 12 = 102 | 90 - 60 + 12 - 70 = 30 - 58 = 30 | 30 - 58 = -28 = 0 |
| Firm 2 | 60 + 57 = 117 | 60 - 90 + 57 - 0 = 27 | 27 |
| Firm 3 | 70 | 70 - 12 + 0 - 57 = 58 - 57 = 58 | 58 - 57 = 1 |
| CCP | 27 + 1 = 28 | Total | 289 |
Firm 1’s exposure to the CCP is 90 + 12 = AUD 102 million; the CCP’s exposure to Firm 1 is 60 + 70 = AUD 130 million. Therefore, Firm 1’s exposure to the CCP is AUD 0 million (= 102m - 130m = -28m = 0). Firm 3’s exposure to the CCP is AUD 70 million; the CCP’s exposure to Firm 3 is 12 + 57 = AUD 69 million. Therefore, Firm 3’s exposure to the CCP is AUD 1 million (= 70m - 69m). Firm 2’s exposure to the CCP is 60 + 57 = AUD 117 million; the CCP’s exposure to Firm 2 is AUD 90 million. Therefore, the CCP’s exposure to Firm 2 is AUD 27 million (= 117m - 90m).
Explanation:
The correct answer is D. Under central clearing, the CCP's net exposure is AUD 28 million. This is determined through the process of novation and netting. In bilateral netting, each firm's exposures to and from other firms are offset against each other. However, under central clearing, all trades are replaced by a single counterparty, the CCP (Central Counterparty), which becomes the buyer to every seller and the seller to every buyer.
Here's the breakdown for each firm and the CCP:
Firm 1 has an exposure to Firm 2 of AUD 90 million and to Firm 3 of AUD 12 million. After bilateral netting, Firm 1's net exposure is calculated as (90 - 60) + (12 - 70) = 30 - 58 = -28, which simplifies to 0 due to the nature of netting. In central clearing, Firm 1's exposure to the CCP is the sum of its gross exposures, 90 + 12 = AUD 102 million, and the CCP's exposure to Firm 1 is the sum of the gross exposures from Firm 1's counterparties, 60 + 70 = AUD 130 million. The net exposure for Firm 1 in central clearing is therefore 0 (102 - 130 = -28, which is considered 0 in this context).
Firm 2 has an exposure to Firm 1 of AUD 60 million and to Firm 3 of AUD 57 million. After bilateral netting, Firm 2's net exposure is (60 - 90) + (57 - 0) = -30 + 57 = 27 million. In central clearing, Firm 2's exposure to the CCP is the sum of its gross exposures, 60 + 57 = AUD 117 million, and the CCP's exposure to Firm 2 is AUD 90 million (from Firm 1). The CCP's net exposure to Firm 2 is therefore 27 million (117 - 90).
Firm 3 has an exposure to Firm 1 of AUD 70 million and none to Firm 2. After bilateral netting, Firm 3's net exposure is (70 - 12) + (0 - 57) = 58 - 57 = 1 million. In central clearing, Firm 3's exposure to the CCP is AUD 70 million, and the CCP's exposure to Firm 3 is the sum of the gross exposures from Firm 3's counterparties, 12 + 57 = AUD 69 million. The net exposure for Firm 3 in central clearing is therefore 1 million (70 - 69).
The CCP's total net exposure is the sum of its net exposures to each firm, which is 27 (from Firm 2) + 1 (from Firm 3) = AUD 28 million.
Options A, B, and C are incorrect based on the calculations and explanations provided. Firm 1's net exposure under bilateral netting is not AUD 28 million but rather AUD 0, Firm 2's net exposure is not AUD 27 million but rather AUD 57 million, and Firm 3's net exposure under central clearing is not 0 but rather AUD 1 million.