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Pretrade and risk-based clearing

Pretrade and risk-based clearing PurposeRisk-based clearing has been proposed by Rausser et al. (2010) for over-the-counter (OTC) derivatives. This paper aims to illustrate the application of risk-based margins to a case study of the mortgage-backed securities derivative portfolio of the American International Group (AIG) during the period 2005-2008. There exists sufficient publicly available information to examine AIG’s derivative portfolio and how that portfolio would depend on conjectural changes in margin requirements imposed on its OTC derivative positions. Generally, such data on OTC derivative portfolio positions are unavailable in the public domain, and thus, the AIG data provide a unique opportunity for an objective evaluation.Design/methodology/approachThis paper uses modern financial methodology to evaluate risk-based margining and collateralization for the major OTC derivative portfolio of the AIG.FindingsThis analysis reveals that a risk-based margin procedure would have led to earlier margin calls of greater magnitude initially than the collateral calls actually faced by AIG Financial Products (AIGFP). The total margin ultimately required by the risk-based procedure, however, is similar in magnitude to the collateral calls faced by AIGFP by August 2008. It is likely that a risk-based clearing procedure applied to AIG’s OTC contracts would have led to the AIG undertaking significant hedging and liquidation of their OTC positions well before the losses built up to the point they had, perhaps avoiding the federal government’s orchestrated restructuring that occurred in September 2008.Originality/valueThere has been no published risk-based evaluations of a major OTC portfolio of derivatives for any company, let alone the AIG. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Financial Economic Policy Emerald Publishing

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Publisher
Emerald Publishing
Copyright
Copyright © Emerald Group Publishing Limited
ISSN
1757-6385
DOI
10.1108/JFEP-10-2015-0059
Publisher site
See Article on Publisher Site

Abstract

PurposeRisk-based clearing has been proposed by Rausser et al. (2010) for over-the-counter (OTC) derivatives. This paper aims to illustrate the application of risk-based margins to a case study of the mortgage-backed securities derivative portfolio of the American International Group (AIG) during the period 2005-2008. There exists sufficient publicly available information to examine AIG’s derivative portfolio and how that portfolio would depend on conjectural changes in margin requirements imposed on its OTC derivative positions. Generally, such data on OTC derivative portfolio positions are unavailable in the public domain, and thus, the AIG data provide a unique opportunity for an objective evaluation.Design/methodology/approachThis paper uses modern financial methodology to evaluate risk-based margining and collateralization for the major OTC derivative portfolio of the AIG.FindingsThis analysis reveals that a risk-based margin procedure would have led to earlier margin calls of greater magnitude initially than the collateral calls actually faced by AIG Financial Products (AIGFP). The total margin ultimately required by the risk-based procedure, however, is similar in magnitude to the collateral calls faced by AIGFP by August 2008. It is likely that a risk-based clearing procedure applied to AIG’s OTC contracts would have led to the AIG undertaking significant hedging and liquidation of their OTC positions well before the losses built up to the point they had, perhaps avoiding the federal government’s orchestrated restructuring that occurred in September 2008.Originality/valueThere has been no published risk-based evaluations of a major OTC portfolio of derivatives for any company, let alone the AIG.

Journal

Journal of Financial Economic PolicyEmerald Publishing

Published: May 3, 2016

References