The primary differences between Cleared & Bilateral Contracts are:
1) How bilateral derivatives were collateralized vs. cleared derivatives which are collateralized more like exchange traded futures and options.
2) How bilateral & cleared derivatives handle Credit Valuation Adjustment (CVA).
Illustrating the risks of a cleared derivative versus a bilateral derivative will better define the risks of each.
Beginning with the risks in common, we can then illustrate how each contract’s risk is captured and collateralized.
EXAMPLE: 5 year swap
“we” the bank are paying fixed & receiving LIBOR
A single currency interest rate swap does not require principal to be transferred. Therefore the counterparty credit risk is isolated to the coupon payments.
The primary swap risks are:
1) Counterparty Credit Risk
2) Volatility Risk
IMPACT OF COUNTERPARTY CREDIT RISK CREDIT RISK
1) If we are paying the fixed rate and rates go down à we are making money
- We will receive collateral from the counterparty
2) If we are paying the fixed rate and rates go up à we are losing money
- We will pay collateral to the counterparty
IMPACT OF COUNTERPARTY CREDIT RISK CREDIT RISK – AS TIME GOES BY
IMPACT OF VOLATILITY
1) Impact of volatility rises as time to maturity increases. Normal Distribution adjusts time by the square root of time.
2) As time passes the range of probable prices increases
VOLATILITY & MARKET RISK MEASURED
3) Maximum Potential Exposure (MPE) is approximately 2.5 years.
4) Pre-Dodd Frank the client would need a 5 yr derivative trading line in the amount of 2.5% of notional to enter into the 5 yr swap.
5) Post-Dodd Frank the client actually posts the 2 ½%; but posts it to a CCP as initial margin.
The site includes much more information about Cleared Derivatives & Bilateral Contracts.
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