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Answer: b) It makes the clearinghouse counterparty to both A and B, greatly reducing their counterparty (default) risk
Novation replaces the original bilateral contract with two new contracts involving the clearinghouse. The clearinghouse becomes the counterparty to both A and B, which materially reduces counterparty default risk because each party now faces the CCP rather than the original trading partner.
Author: Manit Arora
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Question 145.3. If counterparty A is long a forward contract in a bilateral trade with counterparty B, who is short the same contract, what does novation of the contract to the clearinghouse achieve?
A
a) Nothing, it is a purely legal mechanism
B
b) It makes the clearinghouse counterparty to both A and B, greatly reducing their counterparty (default) risk
C
c) It nets (i.e., netting) the contract such that if the new net futures contract value is zero, the contract terminates
D
d) It converts a gross margin (sum of contracts) to a net margin (long contracts minus short contracts)
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