Mitigating Counterparty Risk in OTC Derivatives

Very Hard Derivative Markets And Instruments Over-the-counter Derivatives

In the context of Over-the-Counter (OTC) derivatives, one of the significant risks that market participants face is related to counterparty default. This risk can affect not only the pricing of contracts but also the overall liquidity of the derivatives market. It is essential for investors to understand how different mechanisms are employed to mitigate this risk.

Consider a scenario where two financial institutions enter into an interest rate swap agreement without a centralized clearing house. Which of the following statements most accurately describes a method that is typically used to mitigate counterparty risk in this type of OTC derivative transaction?

Setting a standardized collateral agreement with initial and variation margin requirements based on market value fluctuations.

Regularly reporting and marking-to-market their positions without any formal margining or collateral agreements.

Engaging in bilateral netting arrangements where all exposures are netted to reduce gross counterparty risk.

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