Explanation:
When an institution has a positive mark-to-market (MtM) value on a trade, it faces the risk of default from the counterparty. Therefore, it will request collateral to mitigate this credit risk exposure. Conversely, if the MtM value is negative, the institution is out of the money and the counterparty faces default risk from the institution. In this scenario, the counterparty will request collateral from the institution. Therefore, option B correctly outlines the mechanics of a collateral agreement from the perspective of a financial institution.
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Q.1899 Whenever an institution enters into a trade agreement with a counterparty, there is always the risk of default. A collateral agreement limits risk exposure by posting of collateral by the counterparty at risk of default. From the perspective of the financial institution, this implies that:
A
in case of a positive MtM, an institution will provide collateral. On the other hand, if it has negative MtM value, it will request collateral to reduce its risk exposure.
B
in the case of a positive MtM, the institution will request collateral. If the MtM is negative, the counterparty will request collateral.
C
in case of a negative MtM, the institution will request for collateral. If the MtM is positive, the counterparty will be required to provide collateral.
D
collateral is a constant requirement if the institution has a lower credit rating compared to the counterparty.