Explanation:
Choice A is correct. Mandating all counterparties to provide adequate high-quality collateral is the most effective and direct way to drastically reduce counterparty risk. Collateral serves as a security against the default of a counterparty. If a counterparty defaults, the firm can seize the collateral to cover its losses, thereby significantly mitigating counterparty credit risk.
Choice B is incorrect. Expanding and diversifying the counterparty base might reduce concentration risk but does not eliminate or drastically reduce the inherent counterparty risk of individual exposures, especially in a niche market.
Choice C is incorrect. Cross-product netting can reduce the net exposure to a single counterparty across multiple products, but it doesn't provide a complete safeguard against default if the net exposure remains positive.
Choice D is incorrect. While CDS can provide credit protection, they introduce a new counterparty risk (the risk that the CDS protection seller defaults) and might be difficult, illiquid, or excessively expensive to obtain for a niche derivatives market where only a select few participants exist.
Ultimate access to all questions.
No comments yet.
Q.5436 A specialized trading firm deals exclusively in derivatives tied to uncommon resources. This firm, along with a select few others that hold significant notional contracts with it, largely controls this niche derivatives market. With an aim to drastically reduce its counterparty risk, the firm's leadership is considering various strategies. Which of the options below would most effectively help the firm in achieving its objective?
A
Mandating all counterparties to provide adequate high-quality collateral.
B
Expanding and diversifying its counterparty base.
C
Implementing cross-product netting for individual counterparties.
D
Investing in credit protection instruments like credit default swaps.