Explanation:
To reduce counterparty credit risk to near zero, requiring ample high-quality collateral (such as cash or top-tier government securities) alongside daily margining is the most direct and effective method. Over-collateralization offsets the counterparty exposure almost completely.
Given the niche and highly concentrated nature of the market (few dominant firms, scarce commodities), diversifying counterparties (Option B) may not be practically feasible. Cross-product netting (Option C) reduces gross exposure but does not bring it to near zero. Acquiring credit derivatives (Option D) transfers the risk but substitutes the original counterparty risk for the counterparty risk of the CDS protection seller, which may not eliminate exposure effectively (due to wrong-way risk or the systemic nature of concentrated markets).
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Q.22 A trading firm specializes in derivatives linked to scarce commodities and, along with a few other dominant firms, holds substantial notional contracts in this niche market. The firm's management aims to significantly reduce its counterparty risk exposure, ideally to near zero. Which of the following strategies would be most effective in achieving this objective?
A
Requiring counterparties to provide ample high-quality collateral
B
Expanding the pool of counterparties
C
Implementing cross-product netting agreements with individual counterparties
D
Acquiring credit derivatives such as credit default swaps
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