Rarecom is a specialist company that only trades derivatives on rare commodities. Rarecom and a handful of other firms, all of whom have large notional outstanding contracts with Rarecom, dominate the market for such derivatives. Rarecom management would like to mitigate its overall counterparty exposure, with the goal of reducing it to almost zero. Which of the following methods, if implemented, could best achieve this goal?
a. Ensuring that sufficient collateral is posted by counterparties
b. Diversifying among counterparties
c. Cross-product netting on a single counterparty basis
d. Purchasing credit derivatives, such as credit default swaps
Answer:A
Counterparty exposure, in theory, can be almost completely neutralized as long as a sufficient amount of high quality collateral, such as cash or short-term investment grade government bonds, is held against it. If the counterparty were to default, the holder of an open derivative contract with exposure to that counterparty would be allowed to receive the collateral. Cross-product netting would only reduce the exposure to one of the counterparties, and purchasing credit derivatives would replace the counterparty risk from the individual counterparties with counterparty risk from the institution who wrote the CDS.