112.212.3
Profit, Loss, and Financing CostsTwo-factor ArbitrageTrading Strategy
434435437
Chapter 13 Yield Decomposition Model
440
13.113.213.313.413.5
44 1442443444445
Volatility Adjusted DurationDollar Value of ConvexityExpected Total Rate of ReturnMeasurement of Risk PremiumExpectation Curve
Contents
xxii
13.613.713.8
Expected FED Funds RateYield Decomposition AnalysisDiscussion
447447448
Chapter 14 Inflation Linked Instruments Modeling
450
14.114.2
45 1452453453453454454455456457458460
14.2.114.2.214.2.314.2.414.2.5
14.314.414.514.614.7
lnflation SwapsFunctions and ApplicationsAssetLLiability ManagementInflation Swaps as Hedging and Trading InstrumentsInvestment AlternativesInflation Linked Debt IssuanceComplementary to Interest Rate SwapsInflation Swap LevelReal Rate Swap CurveZero-coupon Inflation Swap Curve Valuation MethodsRisk Measures and HedgingProspect of the Inflation Swap Business
Chapter 15 Interest Rate Proprietary Trading Strategies
461
15.115.2
RicWCheap TradeRicWCheap Analysis15.2.1 Yield Curve Sector RicWCheap Analysis15.2.2 RicWCheap Analysis for Notes and Bonds15.3BondSwap Trade15.4Curvature Trade15.5Spread Trade15.6Box Trade15.7OAT Floater Trade15.8CasWutures TradeA Generic Convergence Trading Strategy15.9Other Factors Related to Trading Strategy15.1015.10.1 Transaction Cost15.10.2 Higher Risk and Highly Profitable Trades15.10.3 Bet Big When All Components Line Up15.10.4 Human Judgment
462464464466468469470472472473473476476477478478
References
479
Index
491
PART I
THEORY ANDAPP LlCATlONSOF DERIVATIVESMODELING
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Chapter I
Introduction toCounterpartyCredit Risk
Even though the credit risk in various underlying assets and referenceobligations has been trading in the market for many years or decades interms of, e.g., risky bonds and credit derivatives, the trading of thc counterparty credit risk in derivatives instruments is a relatively new field.The counterparty credit risk comes from the fact that as one entersinto an OTC (over-the-counter) derivatives transaction, one (implicitly orexplicitly) grants one’s counterparty an option to default and, at the sametime, one also receives an option to default oneself. Equivalently, in thetransaction, one sells credit protection on one’s counterparty to one’scounterparty and buys credit protection on oneself from one’s counterparty. Various authors have published research papers on how to modelthe counterparty credit risk.2In essence, pricing the counterparty credit risk is the same as pricingdefaultable derivatives (or defaultable baskets of derivatives) or the default prcmium in derivatives (or baskets of derivatives), which is a relatively new area of the derivatives modeling. In some cases, the counterparty credit risk is more significant than any other risks and a derivativesinstrument becomes a hybrid derivatives instrument with credit or acompound credit derivatives instrument if the underlying derivatives instrument is a credit derivatives instrument.For instance, a plain vanilla intcrcst rate (IR) swap becomes a defaultable IR swap. Also, in the prevailing credit derivatives, pricing aSee, e.g., Litzenberger (1992), Duffie and Huang (1996), Jarrow and Tumbull (1995),and Jarrow and Yu (2001).
4
Introduction to Counterpar9 Credit Risk
Chapter 1
credit default swap (CDS) is essentially to price the default premium inthe underlying bond or asset, whereas pricing the counterparty credit riskis to price the default premium of the default protection seller of the CDSor, more precisely, the premium of the joint default of the underlyingasset and the default protection seller.The term of counterparty credit risk may remind the reader of a backoffice risk management functionality. We emphasize that it should be anintegral part of the front office derivatives pricing, trading, and hedgingactivities, which is the same as pricing, trading, and hedging defaultablederivatives. This is the approach that we shall adopt in this book and weshall also address many practical issues. With this approach, a large partof the counterparty credit risk becomes market risk that can be traded andhedged with market oriented trading strategies (in addition to the classical strategies for counterparty credit risk management),Just like the credit risk in a bond (with respect to the bond issuer)reduces the market value of the bond (relative to the same bond that isdefault-free), the counterparty credit risk should also reduce the marketvalue of one’s (net) receivables in an OTC derivatives instrument (relative to the same receivables that are default-free).The PV (present value) of the counterparty credit risk can be a significant percentage of the overall P&L (profit and loss) of the derivativesdesks and can reach many hundreds of millions of dollars for a top investment bank. In other words, typically, one’s overall profit needs to bemarked down by the PV of the (net) counterparty credit risk that onetakes.The PV of the counterparty credit risk needs to be actively hedgedand risk managed, just like other risks in derivatives trading. Simpleback of envelop calculations can show that the credit spread PVOl of thecounterparty credit risk can reach several millions of dollar^.^ This is ahuge Delta exposure to a market maker or dealer.4Even before default happens, the counterparty credit risk can haveThe credit spread PVOl is the PV change for Ibp increase of the credit spread. lbp isone hundredth of 1%. For the credit spread PVOl estimation, we have assumed that theaverage or equivalent counterparty credit spread is about 100 to 200bp. Then, the creditspread PVOl can be estimated by the PV of the counterparty credit risk divided by thecredit spread. Similarly, we can also estimate the loss given default (LGD). For details,please refer to Chapter 8.By market maker or dealer, we typically mean OTC derivatives market maker or dealer,unless otherwise indicated. We often use the word “market marker” and “dealer” interchangeably.
Sec. 1.1
Credit Charge, Credit Benefit, and Credit Premium
5
significant impact on trading and hedging strategies in many ways, suchas in the pricing of cash-settled versus physically settled options, theearly exercise decisions of Bermudan or American options, as well as theput-call parity and the bidask spread.There are also arbitrage strategies that one can employ to capitalizeor monetize the counterparty credit risk, which can bring in cashflows insome cases and reduce the outgoing cashflows in some other cases.These strategies can also be applied to achieve trade price cheapening toone’s counterparties and thus can bring in more business. In otherwords, while one usually needs to charge a premium from one’s counterparty due to the counterparty’s default risk, one can actually structure atrade whereby one pays a premium to one’s counterparty due to thecounterparty’s likelihood of default. The reader may want to think abouthow to structure such a trade and we shall come back to this point lateron.All these have created and will create more trading opportunities inthe market and are major driving factors for the development of thecredit hybrid market and modeling.It is important to point out that these arbitrage strategies are not thecase that financial institutions arbitrage against one another, but rather toachieve the fair values of the default probabilities and recoveries pricedby the market, which is a less transparent area. Not only can these arbitrage strategies benefit individual firms, they can also make the marketmore transparent and efficient with more information discovery and production, including possibly more implied views on the default events andrecoveries.In the current practice, the PV of the counterparty credit risk entersinto the MTM (mark-to-the-markets) values for the corresponding portfolios as credit valuation adjustments (CVA) or the credit charge or premium. The IRS (Internal Revenue Service) also cares about this for taxpurposes, which is highlighted by the BankOne case in United States Taxcourt.6Proper pricing and management of counterparty credit risk are important to a firm’s long-term economic soundness and can help reducingOr mark-to-the-model, if mark-to-the-market values are not easily obtained, which iscommon in OTC derivatives business, especially for exotic derivatives.For more details on the case of BankOne regarding the swap valuation, see, e.g., theExpert Report of Darrell Duffie (http://www.stanford.edu/-duffie/bankone.pdf)and thecourt’s ruling (http://www.ustaxcourt.gov/InOphistoric/.
6
Introduction to Counterparty Credit Risk
Chapter 1
the potential default losses and to increase its earnings and/or reduce theearning volatility, which will help to increase the shareholders’ equityandor reduce its volatility. It is also beneficial to a firm’s bondholdersand other investors, as well as the economic soundness of the entire financial industry. Proper management of the counterparty credit risk canalso help banks reduce the amount of their regulatory capital, particularlyunder the forthcoming Basel I1 Accord? and thus boost the return onregulatory capital. This, in turn, will create more trading opportunities inthe market place.Proper pricing and management of the counterparty credit risk arealso critical for a financial institution to expand its derivatives businessto non-investment grade counterparties, such as high yield and emergingmarket counterparties. In these cases, the PV of the counterparty creditrisk can be significantly outside of the broker’s bidask spread of theunderlying derivatives trade, in which case, one is really trading thecounterparty credit risk more than any other risks and the underlying derivatives trade becomes a hybrid derivatives instrument with credit or acompound credit derivatives instrument.As we shall see, the prevailing derivatives models focusing on pricing of specific trade (which we shall term as trade-level or micro models)normally do not and often cannot price the (specific) counterparty creditrisk, even though they can price expected market risks, expected creditrisks in the underlying assets or reference obligations in the case of creditderivatives, and some generic counterparty credit risk. This is due to thatthe specific counterparty credit risk is essentially a basket option on thecounterparty portfolio and has highly non-linear portfolio effect. Therefore, additional portfolio level models (which we shall term as macromodels) are needed for pricing the specific counterparty credit risk.Another area that the trade-level or micro derivatives models normally do not and often cannot price accurately are the unexpected risks,such as VAR (Value at Risk)8 and PE (Potential Exposure)’ that can contribute to the hedging cost and are the driving factors for the regulatorycapital cost. Pricing of such unexpected risks need the portfolio level ormacro models and can leverage similar models and system infrastruc-
’For more information, see www.bis.org.
* Coherent risk measures, such as the expected tail loss (ETL) or the expected shortfalls,
are superior to VAR due to their subadditivity.Credit VAR or credit coherent risk measures are superior to PE due to their capabilitiesof handling portfolio effects or benefit of diversification.
Sec. 1.1
Credit Charge, Credit Benefit, and Credit Premium
7
tures used for pricing the counterparty credit risk. In addition, in order toaccurately model the bidask spread, one also needs the portfolio level ormacro models.We shall address various subtleties in the counterparty credit risk,some of which come from the asymmetry of the prevailing default treatment and its impact on the default recovery. In other words, if the defaulting party is in the money on the portfolio with a counterparty," thenupon the default, to the first order, all the trades are terminated as if therewere no default and the defaulting party will be paid the MTM of theportfolio by its counterparty, and, thus, to the first order, there is no default loss or gain to either party. On the other hand, if the defaultingparty is out of the money on the portfolio with a counterparty, then uponthe default when all the trades are terminated, the defaulting party willonly need to pay a fraction of the net MTM of the portfolio, i.e., the recovery on the portfolio, to its counterparty and thus the defaulting partywill have a default gain and its counterparty will have a default loss."One particular subtle and interesting issue in the counterparty creditrisk is how to realize (or monetize) and lock in one's default gain beforeone defaults, i.e., how to convert one's default gain into a stream of cashflows before one defaults. This is very important to the business as thePV of such default gain can possibly reach hundreds of millions of dollars for a top investment bank. There are trading and arbitrage strategiesavailable for this, some of which shall be discussed later on.It seems that there are dealers who do not accurately price in thecounterparty credit risk in their trades and portfolios. If they price thecounterparty credit risk too aggressively (or too low), then, not only theyare exposed to the default risk of their counterparties without propercompensation, they are also exposed to the credit spread risk of theircounterparties without proper compensation. If they price the counter-
''
To be more precise, it is on the net basis for each of the netting node, i s . , a collectionof legally and enforceably nettable trades. Going forward, for the simplicity of disposition, when we refer to a counterparty portfolio, we mean a netting node in the portfolio,unless indicated otherwise. When we say that one is in the money on a portfolio, it is thesame as saying that one has a positive net MTM value or a positive exposure on the portfolio, one is owned money on the portfolio, one has net receivables on the portfolio, andthe portfolio is ones' asset. Similarly, when we say that one is out of the money on aportfolio, it is the same as saying that one has a negative net MTM value or a negativeexposure on the portfolio, one owes money on the portfolio, one has net payables on theportfolio, and the portfolio is one's liability.I ' If there are collaterals involved, then MTMNC (MTM net of the collaterals) is what isat risk and should be used in the discussion.
8
Introduction to Counterparty Credit Risk
Chapter 1
party credit risk too conservatively (or too high), they may lose businessopportunities to other dealers.One subtlety is that it may not be inline with the interests of the traders and the trading desks. Thus, the successful implementation of models, systems, and policies for proper management of counterparty creditrisk often requires the support of top executives in a firm, such as thehead of derivatives trading business and the CFO (Chief Financial Officer).In addition, the quantification or modeling of counterparty credit riskand its management also impose challenges and additional requirementson pricing theory, pricing engine, trading system architecture, and backoffice process, and require dedicated human resources and dedicated systems. Nonetheless, these challenges and the benefit to be capitalized byovercoming these challenges will open up new opportunities in, e.g.,trading and modeling.In summary, without proper modeling and management of counterparty credit risk, one is missing a significant part of the big picture ofOTC derivatives modeling and business.This chapter focuses on concepts and intuitions. Detailed modelingissues are discussed in later chapters.
1.I
Credit Charge, Credit Benefit, and Credit Premium
The question is after one enters into an OTC (over-the-counter) derivatives transaction or trade, what else can happen? Of course, one’s counterparty can default. But, there is more - one can default oneself too.In other words, when one enters into an OTC derivatives transactionor trade, one (explicitly or implicitly) grants one’s counterparty an optionto default’* (or is short of counterparty default protection). Similarly,one also receives an option to default (or is long of self default protection) from one’s counterparty. In a rational and efficient market, eachparty should be compensated for the credit risk that they undertake andl 2 Such default options may not be explicitly on the term sheet of the derivatives transaction. Nonetheless, such default options are real and defaults do happen. The default canhappen exogenously or endogenously. By using the word “option”, we do not mean thatthe default always happens endogenously. Rather, we use the word ‘option” in the senseof the Merton framework whereby the default of a bond is characterized as a (down-andin) put option. Furthermore, the bond holder has a short position in this option and thebond issuer has a long position in this option. Similarly, a stock is equivalent to a longposition on a (down-and-out) call option.
Sec. 1.1
Credit Charge, Credit Benefit, and Credit Premium
9
the net PV (present value) of such default options should also be reflected in the price or PV of the OTC derivatives.In other words, the price or premium of a trade can be broken downinto a few parts, such as the market price (for capturing the market valueand risk in the trade without the consideration of the counterparty creditrisk, but including the value and credit risk from the underlying obligations) and the credit premium (for compensating the counterparty creditrisk in the trade).I3 The market price is what brokers quote or what trading systems or models normally report. The credit premium is a relatively less explored and less transparent area in market practice, Quantmodeling, and trading systems.These default options should be treated much the same way as theunderlying trades. When additional OTC transactions occur (includingthe termination and assignment of an existing trade), the correspondingtransactions of these default options will also occur. More specifically,when OTC derivatives terminate, the associated default options also terminate. For dealers, these default options should be hedged in a similarway as other trades.The PV of the default option of one’s counterparty is one’s expecteddefault loss (due to the counterparty’s default), which translates to one’scredit charge. This is also the credit valuation adjustment for one’s asset,or CVA asset. On the other hand, the PV of the default option of oneselfis one’s expected default gain (due to one’s own default), which translates to one’s credit benefit. This is also the credit valuation adjustmentfor one’s liability, or CVA liability.Theoretically, e.g., ignoring the bidask spread, in order for the twoparties to agree on the same price on the trade, we need the symmetry ofthe credit charge and credit benefit, i.e., one’s credit charge is one’scounterparty’s credit benefit, and vice versaThe total or net credit charge or the credit premium is the net PV ofthe two default options or the net of the credit charge and the credit benefit. Similarly, the net CVA is the net of the CVA asset and the CVA liability.
l 3 It should also include premium of unexpected risk and liquidity premium.
10
Introduction to Counterparty Credit Risk
Chapter 1
Figure 1.1 depicts a more complete picture of OTC derivatives trade.
4
PartyA
4t
PDOB
Original Trade
PartyB
DOAPDOA
b
Figure 1.1. A more complete picture of an OTC derivatives trade. More specifically, in addition to the original trade, Party A implicitly grants a default optionto Party B (DOB) and Party B pays Party A a premium (PD,,) for such defaultoption, and vice versa. Thus, the derivatives trade is actually a credit hybridtrade. In the case of credit derivatives, the derivatives trade itself can also reference the default of underlying asset(s) or obligations(s), in which case the trade isa compound credit derivatives trade.
The readers may recognize that we emphasize the attribution of thecounterparty credit risk to real (albeit embedded) trades or default options, whereas some of the prevailing approaches simply use creditvaluation adjustments (CVA). While these approaches give the samevaluation adjustments, our approach can help us gain insights and intuitions, adopt more market oriented approaches to modeling and management of the counterparty credit risk, and avoid confusions in many cases,as, in our approach, the adjustments are explicitly associated with thesources (i.e., the default options).Some of these cases include trade termination, restructuring, and assignment. It is interesting to analyze the classic example whereby PartyA has a trade with Party B and then Party B assigns the trade to Party C.Particularly, Party C can have no existing trade, or existing offsettingtrades, or non-offsetting trades with Party A.Let’s make a simple comparison between the premium of a CDS andthe credit charge. The premium of a CDS is the default premium (or theprotection premium on such default) in an underlying bond, whereas thepremium of the credit charge is the default premium (or the protectionpremium on such default) in an underlying OTC derivatives instrument.
Sec. 1.1
Credit Charge, Credit Benefit, and Credit Premium
11
Question 1.1. Analyze in details what happens when Party A has a tradewith Party B and then Party B assigns the trade to Party C.Commonly, the net credit charge or the credit premium (or the netCVA) is not paid as a lump-sum upfront premium, but rather is structured into the original trade as a series of cashflows in terms of, e.g., a(additional) funding spread or an annuity leg. In this sense, the counterparty default options are structured similar to credit default swaps (CDS),except the defaults payoffs of the counterparty default options can behighly stochastic (or volatile). In this case, the credit premium will notbe paid in full should the credit premium paying party default before theend of the trade, thus additional credit premium (on the credit premiumitself) needs to be charged to cover the potential loss of the credit premium itself.In general, one’s credit charge would make the trade more expensiveto one’s counterparty, and one’s credit benefit would make the trade lessexpensive. The net credit charge or the credit premium can make thetrade price or PV go either way, depending on, e.g., the credit quality andexposure differential between the two parties. Similarly, the impact ofthe net credit charge or the credit premium on the trade price or PV (orthe par coupon, the funding spread, etc.) can be within or outside thebroker’s bid/ask spread that does not take into account specific counterparty credit risk and, for the swap market, assumes all the parties are ofLIBOR14credit quality.If one of the parties is of low credit quality, particularly, if one of theparties is a high yield name or of non-investment grade, then the impactof net credit charge can be significantly outside of the broker’s bid/askspread. For this situation, the market has started to explicitly providequotes on the net credit charges.Based on the asymmetry of default treatment that we discussed earlier, we can also see that one party’s default would cancel the option todefault of the other party going forward. Therefore, these default optionsare first-to-default options. The first-to-default feature is typically notsignificant unless one of the parties involved is of very low credit quality.l4 LIBOR stands for London Interbank Offered Rate.www.bba.0rg.uk.
For more information, see
12
Introduction to Counterparty Credit Risk
Chapter 1
Often times, the portfolio of a counterparty can contain trades modeled by different pricers, booked in different systems, from differentdesks, or even from different product areas. Accurately pricing optionson such portfolio is one of the most challenging tasks in modeling thecredit charge.Due to the option feature of the credit premium, simple financial instruments, such as forwards and swaps that, by themselves, do not haveVegas,” now can have Vegas for their net PVs due to the credit premium. In addition, the incremental credit premium of a trade with acounterparty depends on other existing trades with the same counterParty.The counterparty credit risk can have significant impact on tradingstrategies and decisions in many ways. For instance, if one is long aBermudan or American option, then one is faced with making decisionswhether to early exercise or to continue. Such decisions (or early exercise boundaries) can be different with or without the consideration of thecounterparty credit risk. To the first order, the credit premium shouldcome into the early exercise decision as exercise or non-exercise gain orcost, depending on whether the credit risk decreases or increases uponthe early exercise. Ideally, a trade with significant counterparty creditrisk should be treated as hybrid derivatives and priced and risk managedas such.
Question 1.2. Analyze in details how the credit premium (or the netcredit charge) affects the early exercise decision.Another example concerns cash settled swaptions versus physicallysettled swaptions. Without the consideration of the counterparty creditrisk, these two settlement types would result in the same PV for a swaption.16 However, these two settlement types can result in a significantl5 Vega is the sensitivity of the PV of a trade with respect to volatility. If a swap ishedged with futures contracts, the swap plus its hedges can have a minor Vega due to theconvexity adjustment.l6 There is another type of cash settlement, cash discount, whose settlement amount, instead of a dealer poll, is determined by PV’ing the underlying swap discounted using thefuture swap rate at the swaption expiry (or, equivalently, assuming the yield curve is flatwith the yield equal to the future swap rate at the swaption expiry). This would make aPV difference as compared to the other settlement types even without the considerationof the counterparty credit risk.
Sec. 1.1
Credit Charge, Credit Benefit, and Credit Premium
13
difference in the credit premium or the net credit charges.A further example is the common put-call parity needs to be modified, which we shall quantify in Section 3.3.It is important to point out that the prevailing micro or trade-levelmodels do incorporate some generic counterparty credit risk. For instance, they normally use LIBOR to discount the derivatives payoffs.This takes into account LIBOR credit quality, which is normally lowerthan that of the Treasury of the corresponding domestic currency (exceptfor lower credit rated sovereign entities). Therefore, the premium of thecounterparty default options that we have been discussing should be relative to the LIBOR credit quality or to capture the default options notpriced in (or priced accurately) by the LIBOR credit quality. In otherwords, if one is below the LIBOR credit quality, one needs to pay a positive premium for one’s option to default, whereas if one is above theLIBOR credit quality, then one can get paid for the fact that one’s defaultoption is of lower premium than that of the LIBOR credit quality whichis priced in the derivatives price.To build intuition on the credit charge, credit benefit, and credit premium, it is often helpful to think that derivatives are similar to loans insome sense. For instance, if one has payables to one’s counterparty in aderivatives trade, then, roughly speaking, one has a loan (or borrowedmoney) from one’s counterparty. The prevailing micro or trade-levelmodels tell us that the loan is priced at LIBOR flat or one has borrowedmoney at LIBOR flat. This clearly is a benefit - the credit benefit, if oneis below the LIBOR credit quality, as one would need to borrow moneyat LIBOR plus a positive spread, if one were to issue a senior unsecuredbond.17 In other words, the credit benefit in this case is one’s saving onone’s funding cost, the cost resulting from the positive spread aboveLIBOR. If one is above the LIBOR credit quality, then getting a loanfrom a derivatives trade at LIBOR flat is actually a cost, rather than acredit benefit.Similarly, under various simplified assumptions, one can decomposeone’s trade into two parts, i.e., a receivable part and a payable part, andthen one should PV the receivables by discounting at the funding rate ofone’s counterparty and PV the payables by discounting at one’s ownfunding rate.Going forward, we shall always use LIBOR as the reference credit” Typically, the (uncollateralized) OTC derivatives are of the same priority in the capitalstructure as senior unsecured bonds.
14
Introduction to Counterpar@ Credit Risk
Chapter 1
quality, unless otherwise indicated. Similarly, we shall also assume thatthe entities involved are of LIBOR credit quality or lower for the simplicity of disposition. The treatment of entities with credit qualities better than LIBOR is similar. Essentially, as we pointed out earlier, we justneed to price the specific counterparty credit risk not priced in or notpriced accurately by assuming LIBOR credit quality in micro or tradelevel pricing models.When sovereign credit risks are involved, there are additional subtleissues that we need to handle, which we shall discuss later on.
1.2
Credit Cost, Accrued Funding Cost, and Accrued FundingBenefit
Aside from credit charge and credit benefit, there is another quantity ofimportance. That is the credit cost.While the credit charge on a counterparty portfolio comes from thescenarios of one’s counterparty’s default when one is in the money in theportfolio (net of collaterals received) and the credit benefit comes fromthe scenarios of one’s own default when one is out of the money in theportfolio (net of collaterals posted), the credit cost comes from the scenarios when one is in the money in the portfolio (net of collaterals received) and one defaults on one’s hedges or funding obligations for theportfolio (net of collaterals received).18To put it in another way, if one has receivables from a counterpartyportfolio, then one needs to charge one’s counterparty the credit charge(to cover one’s potential loss due to one’s counterparty’s default). Similarly, if one has payables from a counterparty portfolio, then one needs topay one’s counterparty the credit benefit (to cover one’s counterparty’spotential loss due to one’s own default).On the other hand, if one has receivables from a counterparty portfolio, then one also incurs the credit cost (cover the potential loss in theone’s funding obligation, such as one’s senior unsecured bonds, due toone’s own default), In other words, the credit cost is the credit charge
’’
It is important to point out that in order to use the collaterals received to offset one’scredit cost, one must be allowed to rehypothecate these collaterals, or reposting thesecollaterals to another party, e.g., to obtain funding at the rep0 rate of these collaterals.Rehypothecation, which makes the market more efficient, is a common practice in theU.S. market. In the cases where rehypothecation is not allowed, then one cannot use thecollaterals received to offset one’s credit cost.
Sec. 1.2
Credit Cost. Accrued Funding Cost, and Accrued Funding Benefit
15
charged by one’s bond holders that is a part of the bond price as pricecheapening or yield enhancement as compared to a LIBOR quality bond.The credit cost should be handled differently from the credit chargeand credit benefit. In other words, unlike the credit charge and creditbenefit, in an efficient market, the credit cost should not be passedthrough to one’s counterparty.More specifically, in an efficient market, if one tries not to pay thecredit benefit andor tries to pass the credit cost to one’s counterparty,then one’s counterparty can arbitrage and enter the same trades with entities of better credit quality. It is important to point out that one does notnecessarily lose money by paying credit benefit and by not passing thecredit cost to one’s counterparty, as one can apply arbitrage tradingstrategies to make a profit and monetize the credit benefit and credit cost.If one does not apply these arbitrage trading strategies, then one wouldlose money. And the lost money would benefit one’s creditors, such asbond