Alpha Bank, a small bank,has a long position with larger BetaBank and has an identical short position with another larger bank GammaBank. Each large bank requires a 20% initial collateral to support the trade. As prices fluctuate in either direction, one large bank will require additional collateral from the small bank, while the risk of loss to the other large bank will increase.

Alpha Bank, a small bank,has a long position with larger BetaBank and has an identical short position with another larger bank GammaBank. Each large bank requires a 20% initial collateral to support the trade. As prices fluctuate in either direction, one large bank will require additional collateral from the small bank, while the risk of loss to the other large bank will increase.

By running the trades through a clearinghouse, the small bank can achieve all of the following objectives EXCEPT:
A . Eliminating the collateral requirement
B . Protecting itself against increases in future collateral demands
C . Protecting against the risk of the failure of one of the large banks
D . Mitigating option hedging risks and altering margin requirement

View Answer

Answer: D

Explanation:

Running trades through a clearinghouse provides several advantages for the small bank, including:

Eliminating the Collateral Requirement:

The clearinghouse nets positions and reduces the need for bilateral collateral postings.

Protecting Against Increases in Future Collateral Demands:

Centralized clearing reduces the potential for unexpected margin calls as prices fluctuate.

Protecting Against the Risk of the Failure of One of the Large Banks:

The clearinghouse acts as a central counterparty, reducing the impact if one large bank fails.

However, the clearinghouse does not specifically address option hedging risks or alter margin requirements directly related to options. Therefore, the correct answer is that running trades through a clearinghouse does not achieve the objective of mitigating option hedging risks and altering margin requirements.

References Source: How Finance Works?