Bilateral Exposure in the Presence of Margin

Leif Andersen, Michael Pykhtin and Alexander Sokol


Collateralisation has long been a standard technique of mitigating counterparty risk in OTC bilateral trading. The most common collateral mechanism is variation margin (VM), which aims to keep the exposure gap between portfolio value and posted collateral below certain, possibly stochastic, thresholds. Even when the thresholds for VM are set to zero, however, there remains residual exposure to the counterparty’s default resulting from a sequence of contractual11The various collateral mechanisms, including the precise definition of variation margin thresholds, are typically captured in an International Swaps and Derivatives Association (ISDA) Credit Support Annex (CSA), a portfolio-level legal agreement that supplements an ISDA Master Agreement. See Chapter 1 for more details. and operational time lags, from the last snapshot of the market for which the counterparty would post in full the required VM to the termination date after the counterparty’s default. The aggregation of these lags results in a time period, known as the margin period of risk (MPoR), during which the gap between the portfolio value and the collateral can widen. The length of the MPoR is a

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