Explanation:
D is correct. Special purpose vehicles are created by a company to legally separate the credit risks of the assets in the SPV and the credit risk of the company.
A is incorrect. Typically, outstanding derivatives are valued on a daily basis and collateral is adjusted daily based on this revaluation.
B is incorrect. A netting agreement will offset long and short exposures in the same underlying asset to the same counterparty, but not across multiple counterparties. Exposures in customized derivatives can also not be netted because the underlying terms and conditions are different.
C is incorrect. A credit default swap embedded in a derivative contract would be useless if either party defaulted. The purchaser of credit default swap is purchasing insurance from another third party if the counterparty of the derivative contract defaults.
Learning Objective: Identify risks associated with OTC markets and explain how these risks can be mitigated.
Reference: Global Association of Risk Professionals, Financial Markets and Products (New York, NY: Pearson, 2023). Chapter 5. Exchanges and OTC Markets
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Q-29. A risk manager is examining the impact of counterparty credit risk in the OTC derivative markets. The manager notes that OTC market participants have adopted several different techniques to mitigate this credit risk. Which of the following correctly characterizes one of these techniques?
A
Requiring the recalculcation of the collateral value and posting of the collateral on a quarterly basis
B
Providing for netting agreements that offset customized bilateral OTC derivative exposures across multiple counterparties
C
Requiring a credit default swap to be embedded in a derivatives contract to protect both parties from a default of the other party
D
Creating special purpose vehicles (SPVs) that legally separate the credit risks of the assets held within the SPV from the credit risk of the company that sponsors the SPV
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