forex collateral
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If you trade the forex markets regularly, chances are that a lot of your trading is of the short-term variety; i. From my experience, there is one major flaw with this type of trading: h igh-speed computers and algorithms will spot these patterns faster than you ever will. When I initially started trading, my strategy was similar to that of many short-term traders. That is, analyze the technicals to decide on a long or short position or even no position in the absence of a clear trendand then wait for the all-important breakout, i. I can't tell you how many times I would open a position after a breakout, only for the price to move back in the opposite direction - with my stop loss closing me out of the trade. More often than not, the traders who make the money are those who are adept at anticipating such a breakout before it happens.

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Forex collateral

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Morgan Stanley is generally engaged in a broad spectrum of FX activities, including with respect to equity and fixed income securities that are denominated in a foreign currency for a variety of purposes. The FX markets are predominantly principal markets.

Thus, Morgan Stanley will typically face its clients as principal when executing trades resulting from FX Transaction Requests and does not generally act as an agent, broker or fiduciary with respect to market making activity. We employ reasonably designed means to minimize market impact and stand ready to discuss market pricing and execution levels with you at your request.

Morgan Stanley may enter into transactions in the relevant or related instruments through internal sources of liquidity or in the market at different times and prices in order to execute your FX Transaction Request and offset the risk incurred, and ultimately provide you with an overall fill that takes into account these transactions. We may choose to leave our principal position unhedged or partially hedged, and may adjust any hedge from time to time in our sole discretion.

In order to unwind a hedge, we may need to unwind our principal position by trading in the relevant or related instruments. Regardless of whether or how we choose to hedge, any profit or loss resulting from any hedging activity will accrue solely to Morgan Stanley. When negotiating any particular FX Transaction Requests with us, you may ask that we not trade as a principal ahead of, or alongside, your transaction, or that we execute in a certain manner, such as through the use of algorithms.

Please note that such a request may limit the execution services we are able to offer you in any particular case. Morgan Stanley utilizes a number of internally developed tools designed to access both external and internal sources of liquidity in order for Morgan Stanley, as principal, to provide what we deem to be the most favorable bids and offers, and executions, reasonably available under the circumstances. Morgan Stanley may benefit from reduced transaction costs when executing through certain internal or external trading venues and, if we have an investment in, or other relationship with, an external venue, the Firm may receive other benefits as a result of that interest.

In addition, all or a portion of your transaction may be filled by internal sources of liquidity rather than external trading venues. Either way, unless we agree otherwise, Morgan Stanley will trade in a principal capacity, and your execution levels may be inclusive of what we deem to be a reasonable spread above the price at which Morgan Stanley may transact, or has transacted, with other clients or trading counterparties, in addition to any disclosed fees that may be charged to access particular sources of liquidity.

The price at which you trade with Wealth Management will depend on a number of factors, including those set out below. This list is not exhaustive and Wealth Management may take into account other factors that it considers appropriate in determining that price. In addition, to the extent we execute a trade with you through internal sources of liquidity, and that liquidity is sourced from another client, we may also receive additional compensation on, and fees for, the trade we execute with that other client which will be included in the spread charged to that client.

The type of product, transaction and market in which the product would be traded, such as:. Internal costs to Morgan Stanley, such as counterparty credit risk, hedging and market. FX Transaction Requests may be submitted by your FA electronically or by voice or other traditional communication channels, and there is no guarantee that any FX Transaction Request will be filled, in whole or in part. Orders submitted electronically are time stamped upon receipt by Wealth Management and voice orders that are not subject to immediate execution are time stamped when input into the order management system.

Spot foreign exchange orders that are submitted through your FA, which may include algorithmic order types such as volume-weighted-average-price and time-weighted-average-price orders, may be filled by Morgan Stanley accessing 1 external FX market centers including but not limited to, trading platforms, inter-dealer brokers and 3rd party matching venues , 2 our internal market making desk as a liquidity provider, or 3 our internal Morgan Stanley matching engines.

When we source liquidity internally as the operator of a matching mechanism, we only do so when the price of a trade will achieve executions at prices which we believe are comparable to those visible to us on external FX market centers. These executions are subject to our pre-agreed fee. At and around the same time that we receive your FX Transaction Request, we may also be executing transactions in similar or related products as a result of our market making activities for other clients and to hedge our risk with respect to these products.

In light of this, it is at our discretion as to how we may satisfy your FX Transaction Request and our other market making activities, including as to timing, prioritization, aggregation and manner of execution, as well as the amount and price of your fill. In addition, your transaction will likely include what we believe is a reasonable spread, as described above. There may also be inherent latencies at both internal and external venues that result in delays between the time we receive your requests and the time we execute trades resulting from such requests.

Dealers are in the business of extending credit and receiving collateral from their clients to facilitate trading. A large part of the activity in the foreign exchange market is trading on margin. Dealers allow customers to take positions solely to trade. Ultimately, it plans to trade out of the position. This chapter describes how credit and collateral can be used to support foreign exchange trading.

I review the prominent contractual agreements that form the legal basis for trading on margin. Next I discuss how dealers measure their exposure to the risk of carrying client positions and present a summary of value-at-risk concepts. Next I advance to the role of posted collateral.

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Market risk arises in the sense that there is likely to be some market movement that will occur after the last posting of collateral. For example, the collateral may fall in value irreversibly, such that any haircuts in place do not offset all of the loss. Although the market risk may not result in an actual loss, it still exposes the collateral holder to a significant loss in the event of default.

The margin period of risk MRP is a term that is specific to counterparty risk and refers to the effective time between a counterparty ceasing to post collateral and when the underlying transactions have been closed-out or replaced. Operational risk increases as an institution engages in a higher number of trades. A bank may have thousands of OTC collateral agreements with as many clients. Such a bank may post or receive collateral running into millions of shillings every day, a scenario that comes with large operational costs in terms of human and technological resources.

Holding collateral gives rise to legal risk in that the non-defaulting party may be faced with legal challenges if they attempt to seize and use collateral held to compensate for their loss after a default event. As noted earlier, it is difficult to liquidate collateral at its market value, possibly in stressed market conditions.

When a default event occurs, an institution non-defaulting party will usually seize assets designated as collateral, sell them for cash, and then attempt to initiate new hedges elsewhere. But selling such assets for their true worth in such circumstances is difficult. This is especially true for large volumes of collateral that cannot be sold without triggering some kind of a market shock that might push the price down.

A party in such a situation may decide to sell the assets in smaller quantities, but that also means it exposes itself to market volatility for a longer period. An institution engaged in collateralized transactions faces funding liquidity risk in the sense that it may not be able to meet frequent collateral demands in line with contractual agreements.

Most institutions usually do not have substantial cash reserves or liquid securities that can be leveraged quickly and posted as collateral. Collateral posted in foreign currency is prone to exchange fluctuations. Although this risk can be hedged in spot and forward markets, care must be taken to ensure that it does not result in additional risks for the institution.

Apart from the derivatives market, collateral is also an important concept with regard to mortgages. The risk of strong interdependence between the property value and the default of the mortgagor. The risk of the property value in consideration falling below the outstanding of the loan or mortgage. The risk of the mortgage lender facing legal obstacles and is, therefore, unable to claim ownership of the property in case of default by the borrower.

The risk of funding needs that arise due to collateral terms, especially when collateral needs to be segregated and cannot be rehypothecated. Option B corresponds to market risk and is often called negative equity. Negative equity occurs when the value of a real estate property falls below the outstanding balance on the mortgage used to purchase that property.

After completing this reading, you should be able to: Explain the subprime mortgage Read More. After completing this reading you should be able to: Define credit risk and After completing this reading, you should be able to: Identify counterparty risk intermediaries, You must be logged in to post a comment. After completing this reading you should be able to: Describe the rationale for collateral management.

Describe the terms of a collateral and features of a credit support annex CSA within the ISDA Master Agreement including threshold, initial margin, minimum transfer amount and rounding, haircuts, credit quality, and credit support amount. Describe the role of a valuation agent. Describe the mechanics of collateral and the types of collateral that are typically used.

Explain the process for the reconciliation of collateral disputes. Explain the features of a collateralization agreement. Differentiate between a two-way and one-way CSA agreement and describe how collateral parameters can be linked to credit quality. Explain aspects of collateral including funding, rehypothecation, and segregation.

Explain how market risk, operational risk, and liquidity risk including funding liquidity risk can arise through collateralization. Describe the various regulatory capital requirements. The Rationale for Collateral Management In simple terms, collateral refers to an asset supporting a risk in a legally enforceable way. There are several motivations for managing collateral: By reducing credit exposure, a counterparty is able to get into a relatively higher number of transactions.

Collateral provision sometimes gives an institution the ability to trade. Collateral provision paves the way for competitive pricing of counterparty risk Collateral provision provides institutions with a way of reducing their regulatory capital requirements by transferring or pledging eligible assets. Precisely, parties are allowed to deliberate over the following issues: method and timings of the underlying valuations; the calculation of the amount of collateral that will be posted; the timing of collateral transfers; eligible collateral securities; collateral substitutions; Dispute resolution Haircuts applied to collateral Rehypothecation reuse of collateral securities Triggers that may initiate a tightening or loosening of collateral requirements Remuneration of collateral posted The CSA defines the following parameters: Threshold The threshold is the amount below which collateral is not required.

Initial Margin Also known as independent margin in bilateral markets, the initial margin refers to the extra collateral required independent of the level of exposure. Minimum Transfer Amount This is the minimum amount of collateral that can be called at a given time. Rounding When posting or returning collateral, the quoted amount is usually rounded to a multiple of a certain size to avoid dealing with awkward quantities that may not be deliverable.

Haircut In most cases, it is difficult to liquidate collateral at its market value, possibly in stressed market conditions. Credit Quality Credit quality refers to the creditworthiness of a counterparty as indicated by their credit rating issued by a reputable, widely recognized rating agency. The Role of a Valuation Agent The valuation agent is the party charged with calculating the credit support amount in line with the dictates of the credit support annex.

In general, the valuation agent calculates: The current MTM under the impact of netting; The market value of collateral previously posted taking into account the relevant haircuts; The total uncollateralized exposure; and The credit support amount. The most common assets include the following: Cash Treasury securities Highly rated mortgage-backed securities Investment-grade corporate bonds Commercial paper Letters of credit Equity Most parties prefer cash over any other eligible collateral in part because it is liquid and can be delivered on short notice without too much operational risk.

The Process for the Reconciliation of Collateral Disputes For centrally cleared transactions, collateral disputes are rare and are quickly solved because the central counterparty is the valuation agent. In most cases, a dispute over a collateral call in OTC markets arises due to one or more of the following: Trade valuation methodology Market data and market close time The value of previously posted collateral Application of credit support rules with regard to aspects like threshold and eligible collateral Most disputes have much to do with the non-transparent and decentralized nature of the OTC market.

Whenever there is a dispute, counterparties engage the following resolution steps: The disputing party is required to notify the counterparty of its intention to dispute the exposure or collateral calculation. Two-way vs.

A typical example would be a trade between a high-quality entity such as a triple-A sovereign and a bank. Parties with more or less the same credit quality often prefer this type of CSA. In fact, two-way CSAs are very common in the interbank market and create benefits for both parties. Substitution, Rehypothecation, and Segregation Substitution In some cases, a counterparty may want their collateral returned at some point after posting.

There are two main reasons: The collateral giver may wish to use the securities posted for some other purpose The collateral giver may withdraw the existing collateral if they feel some other collateral is more appropriate and optimal, perhaps due to a change in the state of the OTC market or the economy as a whole. Rehypothecation Rehypothecation, also called re-use, is the process whereby one party receives collateral and then reuses it to honor their collateral obligations with another counterparty.

Segregation Even in the absence of rehypothecation, the risk that collateral posted by a party may not be retrieved remains. Risks that Arise through Collateralization Market Risk Market risk arises in the sense that there is likely to be some market movement that will occur after the last posting of collateral. Operational Risk In the process of handling collateral, several specific operational risks emerge: missed collateral calls; failed deliveries; computer error; human error; fraud Operational risk increases as an institution engages in a higher number of trades.

To reduce operational risks, the following are paramount: Legal agreements that are accurate and enforceable Robust and resilient IT systems that can handle many daily tasks and automate most of them Timely and accurate valuation of all transactions and securities used as collateral Maintaining a databank regarding initial margins, minimum transfer amounts, rounding, collateral types, and currencies for all counterparties Close monitoring of collateral deliveries where a delay or failure to post is considered a potentially dangerous signal Legal Risk Holding collateral gives rise to legal risk in that the non-defaulting party may be faced with legal challenges if they attempt to seize and use collateral held to compensate for their loss after a default event.

Liquidity Risk As noted earlier, it is difficult to liquidate collateral at its market value, possibly in stressed market conditions. Funding Liquidity Risk An institution engaged in collateralized transactions faces funding liquidity risk in the sense that it may not be able to meet frequent collateral demands in line with contractual agreements.

Foreign Exchange Risk Collateral posted in foreign currency is prone to exchange fluctuations. Practice Question Apart from the derivatives market, collateral is also an important concept with regard to mortgages. The risk of strong interdependence between the property value and the default of the mortgagor B.

The risk of the property value in consideration falling below the outstanding of the loan or mortgage C. The risk of the mortgage lender facing legal obstacles and is, therefore, unable to claim ownership of the property in case of default by the borrower D. The risk of funding needs that arise due to collateral terms, especially when collateral needs to be segregated and cannot be rehypothecated The correct answer is B.

Option A represents correlation or wrong way risk. Option D represents funding liquidity risk. Featured Swaps. Subscribe to our newsletter and keep up with the latest and greatest tips for success. Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. Watching these cleared up many of the unclarities I had in my head. Highly recommended. Every concept is very well explained by Nilay Arun.

Crisp and short ppt of Frm chapters and great explanation with examples. Trustpilot rating score: 4. Previous Post Interest Rates. Next Post Operational Risk. During and after the crisis, criticism of the CDO market was more vocal. Mortgages were needed for collateral and by approximately , the supply of mortgages originated at traditional lending standards had been exhausted.

It was a tailor-made bet on subprime mortgages that went "too far. According to journalists Bethany McLean and Joe Nocera, no securities became "more pervasive — or [did] more damage than collateralized debt obligations" to create the Great Recession.

Gretchen Morgenson described the securities as "a sort of secret refuse heap for toxic mortgages [that] created even more demand for bad loans from wanton lenders. CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts of taxpayer money that would be required to rescue companies like Citigroup and the American International Group. In the first quarter of alone, credit rating agencies announced 4, downgrades of CDOs.

They were strongly criticized by economist Joseph Stiglitz , among others. Stiglitz considered the agencies "one of the key culprits" of the crisis that "performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies. Their [the rating agencies] failure to recognize that mortgage underwriting standards had decayed or to account for the possibility that real estate prices could decline completely undermined the ratings agencies' models and undercut their ability to estimate losses that these securities might generate.

Synthetic CDOs were criticized in particular, because of the difficulties to judge and price the risk inherent in that kind of securities correctly. That adverse effect roots in the pooling and tranching activities on every level of the derivation.

Others pointed out the risk of undoing the connection between borrowers and lenders—removing the lender's incentive to only pick borrowers who were creditworthy—inherent in all securitization. Zandi and others also criticized lack of regulation. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards.

CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of asset-backed security. To create a CDO, a corporate entity is constructed to hold assets as collateral backing packages of cash flows which are sold to investors. A common analogy compares the cash flow from the CDO's portfolio of securities say mortgage payments from mortgage-backed bonds to water flowing into cups of the investors where senior tranches were filled first and overflowing cash flowed to junior tranches, then equity tranches.

If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranche investors face the losses first. The risk and return for a CDO investor depends both on how the tranches are defined, and on the underlying assets. In particular, the investment depends on the assumptions and methods used to define the risk and return of the tranches. Thus investors must understand how the risk for CDOs is calculated. The issuer of the CDO, typically an investment bank, earns a commission at the time of issue and earns management fees during the life of the CDO.

The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. This explains why some CDOs became entirely worthless, as the equity layer tranches were paid last in the sequence and there was not sufficient cash flow from the underlying subprime mortgages many of which defaulted to trickle down to the equity layers.

Ultimately the challenge is in accurately quantifying the risk and return characteristics of these constructs. Since the introduction of David Li's model, there have been material advances in techniques that more accurately model dynamics for these complex securities. The issuer of a CDO—usually a special purpose entity—is typically a corporation established outside the United States to avoid being subject to U.

These corporations must restrict their activities to avoid U. Investing, unlike trading or dealing, is not considered to be a trade or business, regardless of its volume or frequency. In addition, a safe harbor protects CDO issuers that do trade actively in securities, even though trading in securities technically is a business, provided the issuer's activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar businesses.

The PFIC and CFC reporting is very complex and requires a specialized accountant to perform these calculations and manage the tax reporting obligations. Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys. Beginning in , the Gramm-Leach-Bliley Act allowed banks to also participate. Investors—buyers of CDO—include insurance companies , mutual fund companies, unit trusts , investment trusts , commercial banks , investment banks , pension fund managers, private banking organizations, other CDOs and structured investment vehicles.

Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities e. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction.

Investors include banks and insurance companies as well as investment funds. Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals. The underwriter of a CDO is typically an investment bank , and acts as the structurer and arranger.

Working with the asset management firm that selects the CDO's portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.

The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDO's rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.

Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle typically a trust incorporated in the Cayman Islands that will purchase the assets and issue the CDO's tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDO's transaction documents and other files. The final step is to price the CDO i. The priority in placement is finding investors for the risky equity tranche and junior debt tranches A, BBB, etc.

It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.

The underwriter is paid a fee when the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on the underlying assets occur. In theory, the asset manager should add value in the manner outlined below, although in practice, this did not occur during the credit bubble of the mids decade.

In addition, it is now understood that the structural flaw in all asset-backed securities originators profit from loan volume not loan quality make the roles of subsequent participants peripheral to the quality of the investment. The asset manager's role begins in the months before a CDO is issued, a bank usually provides financing to the manager to purchase some of the collateral assets for the forthcoming CDO.

This process is called warehousing. Even by the issuance date, the asset manager often will not have completed the construction of the CDO's portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued.

For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to draw down cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.

However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDO's "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities.

Within the confines of the trading restrictions specified in the CDO's transaction documents, the asset manager can also make trades to maintain the credit quality of the CDO's portfolio. The manager also has a role in the redemption of a CDO's notes by auction call. There are approximately asset managers in the marketplace. CDO asset managers, as with other asset managers, can be more or less active depending on the personality and prospectus of the CDO.

Asset managers make money by virtue of the senior fee which is paid before any of the CDO investors are paid and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration—approx 1.

The trustee holds title to the assets of the CDO for the benefit of the "noteholders" i. In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. The following institutions offer trustee services in the CDO marketplace:.

The underwriter typically will hire an accounting firm to perform due diligence on the CDO's portfolio of debt securities. Source documents or public sources will typically be used to tie-out the collateral pool information.

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What is collateral?

Forex trading involves significant risk of loss and is not suitable for all investors. Trade Today. This chapter describes how credit and collateral can be used to support foreign exchange trading. I review the prominent contractual agreements that form the. Leverage is the use of borrowed money (called capital) to invest in a currency, stock, or security. The concept of leverage is very common in forex trading.