Qn: When two counterparties have obligations to each other, the process that potentially reduces the credit risk of one counterparty to zero and lowers the credit risk of the other is known as:
A) marking to market. B) collateralizing. C) netting.
Answer- C
Explanation: Netting is the process of consolidating the exposures between two parties to a single net exposure that one party bears. Marking to market would not apply to a case where two parties have obligations to each other.
I don’t understand this last line- “Marking to market would not apply to a case where two parties have obligations to each other.” Can someone please explain?
Maybe they mean it would not help the aggregate credit risk to be lower. If one party goes bankrupt and the other owes it money, then (without netting) the other party is still screwed whether you marked to market or not.
Guess: Marking to market usually occurs for futures contracts, therefore your “counterparty” is the clearinghouse, which essentially guarantees the other side of the obligation. The Clearinghouse isn’t your typical “counterparty” that is referred to in the question. Also, because of the gaurantee of the clearinghouse to fullfil the obligation, it never had counterparty credit risk to begin with (theoretically speaking).
What you should focus on: I’m guessing this question is from the Schweser Q Bank? For CFA exam purposes I believe the real underlying issue you want to remember is that netting results in only one party having to make a payment. This would eliminate settlement (Herstatt) risk, which is the risk that one party is preparing to default while the other party is preparing to make its payment.