Explanation:
A default fund is similar to the insurance of all CCP members against the default risk. All the members of the central counterparty (CCP) contribute a specific amount of resources to a pool called a default fund. The default fund is used to pay for the losses of the defaulting counterparty when the defaulting party’s resources are insufficient to cover losses.
Option A is incorrect. Variation margin refers to a margin payment made to the clearinghouse depending on the futures price movements. A member who is trading with the CCP will have to pay the CCP if the price of the traded commodity decreases. The payment made should correspond to the price decline of the commodity. Similarly, if the price of the commodity increases, the CCP will have to pay the member an amount that corresponds to the price increase.
Option B is incorrect. In addition to the variation margin, a trader must deposit an initial margin with the CCP. Initial margins save CCPs from losses if a trader cannot pay the variation margin. The initial margin amount is set by the CCP and is dependent on the changes in the future.
Option C is incorrect. Novation is the term used to describe the transfer of a contract from one party to another party. Interest is usually passed along in such contracts.
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Q.8 Mitigating the counterparty risk is essential to maintain liquidity and reduce systematic risk in the financial system. As an insurance against the counterparty default, all the central counterparty (CCP) members contribute specific resources to a pool that is used if the resources of the defaulting counterparty are insufficient to pay off the losses. Which of the following is the appropriate term used for this pool?
A
Variation margin.
B
Initial margin.
C
Novation fund.
D
Default fund.
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