CMFAS M9A Structured Products question: Requiring a counterparty to post collateral

CMFAS M9AStructured Products

Requiring a counterparty to post collateral is a common way to manage counterparty risk. Which statement is correct?

A Collateral completely eliminates counterparty risk once it has been posted
B Collateral reduces the risk but its value may prove insufficient when called on
C Collateral is never used for OTC structured products, only for listed ones
D Collateral converts a structured product into an equity security issued by the counterparty

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Answer: B. Collateral reduces the risk but its value may prove insufficient when called on

Collateral reduces counterparty risk but introduces collateral risk: the collateral may not have been fully sufficient in the first place, or its value may have deteriorated since it was pledged, so it may not cover the loss when exercised.

Common mistake

Collateral mitigates, but does not remove, the exposure — its own value can fall short.

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