Answer-first summary for fast verification
Answer: Creating special purpose vehicles (SPVs) that legally separate the credit risks of the assets held within the SPV from the credit risk of the company that sponsors the SPV
**Correct Answer: D** **Explanation:** D is correct because Special Purpose Vehicles (SPVs) are indeed used in OTC derivative markets to legally separate the credit risks of the assets held within the SPV from the credit risk of the sponsoring company. This creates bankruptcy remoteness and protects the assets from the sponsor's credit risk. **Why other options are incorrect:** - **A is incorrect**: Typically, outstanding derivatives are valued on a daily basis and collateral is adjusted daily based on this revaluation, not quarterly. - **B is incorrect**: Netting agreements offset long and short exposures in the same underlying asset to the same counterparty, but not across multiple counterparties. Additionally, exposures in customized derivatives cannot be netted because the underlying terms and conditions are different. - **C is incorrect**: A credit default swap embedded in a derivative contract would be useless if either party defaulted. Credit default swaps are purchased from third parties to insure against counterparty default, not embedded within the derivative contract itself.
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A risk manager is examining the impact of counterparty credit risk in the OTC derivative markets. The manager notes that OTC market participants have adopted several different techniques to mitigate this credit risk. Which of the following correctly characterizes one of these techniques?
A
Requiring the recalculaton of the collateral value and posting of the collateral on a quarterly basis
B
Providing for netting agreements that offset customized bilateral OTC derivative exposures across multiple counterparties
C
Requiring a credit default swap to be embedded in a derivatives contract to protect both parties from a default of the other party
D
Creating special purpose vehicles (SPVs) that legally separate the credit risks of the assets held within the SPV from the credit risk of the company that sponsors the SPV
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