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Explanation:
Compression reduces the total notional value of a derivatives portfolio by eliminating redundant or offsetting contracts, allowing a financial institution to maintain its net economic exposure with fewer contracts. This benefits the institutions by requiring less capital to hold an equivalent position and by simplifying risk management.
A is incorrect. Compression does not aim to expand investment portfolios; it aims to make existing portfolios more efficient in terms of notional value and management.
C is incorrect. Although compression can indirectly affect liquidity by making portfolios more manageable, its primary function is not to increase market liquidity directly.
D is incorrect. Compression is not primarily about separating and categorizing risks but about reducing the volume of trades while maintaining the same economic exposure.
Things to Remember
Q.6095 Compression is a key mechanism utilized in central clearing. How does compression benefit financial institutions that hold multiple derivative contracts?
A
It allows them to expand their investment portfolios while maintaining net economic exposure.
B
It consolidates derivative contracts, reducing the number of contracts needed to maintain an equivalent position.
C
It increases market liquidity by expanding the available derivatives that can be traded.
D
It separates and categorizes derivatives based on their risk profiles for better risk management.
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