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Answer: Ensuring that sufficient collateral is posted by counterparties
**A is correct.** Counterparty exposure, in theory, can be almost completely neutralized as long as a sufficient amount of high-quality collateral, such as cash or short-term investment grade government bonds, is held against it. If the counterparty were to default, the holder of an open derivative contract with exposure to that counterparty would be allowed to receive the collateral. **B is incorrect.** The company already has contracts with a handful of other firms that dominate the market for the rare derivatives asked in the question and thus diversification cannot be a solution. **C and D are incorrect.** Cross-product netting would only reduce the exposure to one of the counterparties and purchasing credit derivatives would replace the counterparty risk from the individual counterparties with counterparty risk from the institution who wrote the CDS.
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A derivative trading firm only trades derivatives on rare commodities. The company and a handful of other firms, all of whom have large notional outstanding contracts with the company, dominate the market for such derivatives. The company's management would like to mitigate its overall counterparty exposure, with the goal of reducing it to almost zero. Which of the following methods, if implemented, could best achieve this goal?
A
Ensuring that sufficient collateral is posted by counterparties
B
Diversifying among counterparties
C
Cross-product netting on a single counterparty basis
D
Purchasing credit derivatives, such as credit default swaps
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