How does collateral change the exposure profile of a trade?

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AcadiFi · Accepted Answer

Collateral dramatically compresses both EE and PFE, but the reduction depends on CSA terms: threshold, minimum transfer amount (MTA), frequency, eligibility, haircuts, and margin period of risk (MPR). With a zero-threshold zero-MTA daily-exchange CSA, exposure is bounded above by the MPR-driven gap between collateral and MTM plus potential MTM drift during the MPR. The MPR — the time between the last collateral call and final close-out — is regulatory-set at 10 business days for non-cleared bilateral and 5 days for cleared trades. During the MPR, MTM can drift significantly. For a $500M netting set with Cascadia Frontier Securities, uncollateralized peak PFE might be $48M, while a daily zero-threshold CSA with 10-day MPR reduces peak PFE to roughly $9M — an 80% reduction reflecting only the 10-day diffusion. If you add a $5M threshold plus $1M MTA, peak PFE rises to about $14M because $5M of exposure can go uncollateralized before a margin call triggers. Key insights. First, the MPR is the fundamental residual risk even with perfect daily exchange. Second, thresholds and MTAs leave linear residual exposure. Third, rehypothecation rights affect the effective collateral value. Fourth, wrong-way risk (collateral value correlated with counterparty default) can make collateral less effective — think of equity collateral from a financial counterparty in a systemic crisis. For regulatory capital, collateralized netting sets use the shortfall method with MPR-adjusted exposure.

How does collateral change the exposure profile of a trade?

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