Tuesday, August 10, 2010

guarantor and risk margin in FI trading - Citi context

Recently, FICC trading partners started using 3rd party guarantors. Think of guarantors as private clearing houses who provide integrity, reassurance against counterparty defaults.

Both buyer and seller could open margin accounts with the guarantor, and gain leverage. With leverage/margin comes default risk. As with futures exchange margin accounts, assets are marked to market nightly.

Guarantor takes, ideally, no risk and earns a fee. However, to maintain their zero-risk, they must carefully compute marks and issue margin calls.

At the core, the all-important marking process is basically asset valuation as-if-liquidating, and implemented using VaR. This is what (I guess) how it works -- If VaR says "over next 10 days, in the 1% worst cases our smallest[1] loss is 3%". For margin valuation purpose, we simply say equity is 3% lower than current value??

[1] Contrast conditional VAR. Largest loss is 100% loss

Q: What FICC products use guarantors?
A: Mostly fixed income, not much "CC". Futures contracts usually need a guarantor (i guess the exchange itself -- Futures always trade on exchanges). A lot of derivatives too.

Bond buyers can also benefit from a guarantor. Investor deposits an initial margin amount with the guarantor, buys the bond using the margin account, receives margin calls when valuation drops. If for 2 years she always meets the margin requirement, then she enjoys the leverage advantage -- doesn't need to put up the full capital. Guarantor basically lends money to her to finance her investment.

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