Settlement risk could be illustrated using a

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Settlement risk could be illustrated using a derivatives transaction between two counterparties. At the settlement date, one of them is in a net gain (“winning”) position and the other is in a net loss (“losing”) position. The position that is losing may simply refuse to pay and fulfill its obligations. Continuing with the concept of a net gain position in a transaction, credit risk exists only to that party. If the losing party defaults, then the winning party may lose some or all of that net gain. The portion that is expected to be recovered is called the recovery value and the portion that is expected to be lost is the loss given default (LGD). For example, if a party’s net gain position is $500,000 at settlement and only $400,000 is expected to be recovered, then the recovery value is $400,000 and the LGD is $100,000. Expressed as percentages, the recovery rate is 80% and the LGD is 20%. It is also necessary to consider credit risk within a portfolio of loans. The basic issue is to ensure that the lender charges a rate of interest to the borrower that is commensurate with
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Page 8 ©2015 Kaplan, Inc. Topic 1 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 1 the risk taken. In addition, in order to avoid concentration risk, the lender should ensure sufficient diversification of loans across geographical areas and industries. Somewhat related to concentration risk are correlation risk and overall economic health. Economic recessions will result in more loan defaults and there is tendency for loans in similar geographical areas or industries to default at the same time. Finally, loan portfolios should consider the maturities of the loans and avoid concentration on specific maturities, giving rise to portfolio maturity risk. A more diversified portfolio with loans across a reasonable range of maturities will also help avoid liquidity risk by having more frequent cash inflows (i.e., loan principal repayments) over time rather than having most of the cash inflows at only specified times. Liquidity Risk Liquidity risk is subdivided into two parts: (1) funding liquidity risk and (2) trading liquidity risk. Funding liquidity risk occurs when an entity is unable to pay down or refinance its debt, satisfy any cash obligations to counterparties, or fund any capital withdrawals. Trading liquidity risk occurs when an entity is unable to buy or sell a security at the market price due to a temporary inability to find a counterparty to transact on the other side of the trade. For a transaction that must be executed immediately or in the near future, it might have to be done at a very significant discount, thereby leading to a huge loss. The loss effect is magnified for larger transactions. The impact of trading liquidity risk on an entity could include impairments in its abilities to control market risk and to cover any funding shortfalls.
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