Credit mitigation: Difference between revisions

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The controversial protections in master trading agreements are there for one reason: To stop you losing money. They’re “''[[credit mitigant|credit mitigants]]''”:
#redirect[[credit risk mitigation]]
====[[Event of default|Events of default]]====
*'''Direct [[Failure to pay]]''': If a party [[failure to pay|fails to pay]] or deliver things it owes under the agreement
*'''Indirect credit issues''': Things that increase the likelihood that the party will be unable to do so in the future:
**'''[[Bankruptcy]]''': The party goes [[insolvent]] (or gets close to it)
**'''Credit impairment''': The party’s [[credit rating]]s are prejudiced (via a merger)
**'''[[Cross default]]''': The party breaches important obligations owed to other counterparties
*'''[[Misrepresentation]]''': Things that tend to undermine the comfort you took as to the party’s creditworthiness at the outset of the arrangement, such as representations and warranties no longer being true.
*'''[[Credit support provider]] issues''': similar things happening to  the counterparty’s named guarantors or [[credit support provider]]s.
These [[events of default]] live in the pre-printed the agreement, and tend not to be negotiated (except perhaps [[cross-default]], and that's a whole different story).
====[[Additional termination events]]====
Brokers will usually also require customised “[[additional termination event|additional termination events]]” tailored to the idiosyncrasies of their clients. For example, they will require of [[hedge fund]]s the right to terminate:
*'''[[Key person]] events''': if named individual investment managers cease to be associated with the fund;
*'''[[NAV trigger]]s''': if [[NAV trigger]]s granting close-out rights related to significant decreases in the [[net asset value]] of the fund.
 
These customised events tend to be more controversial, harder to articulate and more complicated: [[NAV trigger]]s may be set at different thresholds over different periods.
 
====[[Netting]] and [[margin]]====
There are less invasive credit mitigation techniques.
*'''[[Netting]]''': Rights to offset positive and negative transaction values under the same agreement upon [[close out]];
*'''[[Margin]]''': The obligation:
**'''[[Variation margin]]''': To regularly transfer cash or assets representing the present net [[mark-to-market]] value of transactions under the agreement;
**'''[[Initial margin]]''':  To transfer assets representing the worst-case market movements in transactions values between [[variation margin]] payments.
So here’s the thing: As long as margin is regularly collected and paid when due, and as long as you’ve correctly calculated the initial margin you need so that it covers any “[[gap loss]]” if  your counterparty goes bust — you’re covered. The moment the counterparty misses a margin call, you have a [[failure to pay]]. It’s the cleanest event there is. You may have to wait out a grace period of a day or two - but you took initial margin to look after that.

Latest revision as of 19:33, 28 August 2017