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Mitigating Investment Risks with Collateral and Liquidity Default Swaps

Mitigating Investment Risks with Collateral and Liquidity Default Swaps. Orion Karl Daley August – 2009 okdaley@gmail.com. Collateral and Liquidity Default Swaps. New Insurance based Financial Instruments Less Risk than older Credit Default Swaps

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Mitigating Investment Risks with Collateral and Liquidity Default Swaps

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  1. Mitigating Investment Risks with Collateral and Liquidity Default Swaps Orion Karl Daley August – 2009 okdaley@gmail.com

  2. Collateral and Liquidity Default Swaps • New Insurance based Financial Instruments • Less Risk than older Credit Default Swaps ( does not impact Insurer’s reserves ) • Sold as policies to Institutional Lenders ( Custodian, Agency, Broker Deal, Agent ) • Purpose: to mitigate risks in Securities Lending and Repo • Low cost – a few basis points above the spread By Orion Karl Daley – August 2009 okdaley@gmail.com

  3. Collateral and Liquidity Default Swaps Conventional Collateral, Equity and Cash Risk Mitigation Generalized Risks Mitigation • Interest Rates Short Term Investments • Exchange Rate “ “ • Term Calls “ “ • Credit Risks Higher Rates • Liquidity Risks Higher Rates • Volatility Short Term Investments By Orion Karl Daley – August 2009 okdaley@gmail.com

  4. Collateral and Liquidity Default Swaps Mitigation through Risk Policy Coverage Risk Condition . . . Mitigation  1- Bond Issuer executes a call option                          -  Get a collateral Default Swap  2- Allowing Low Grade Sec Lending Borrowers       -   Get a Liquidity Default Swap     into a AA rated Auction  3-  Default on Collateral                                                 - Get a Collateral Default Swap 4-  VAR Exceptions  in Inventory                                  -  Get a collateral Default Swap( Derivatives, baskets, newbie, etc ) 5- VAR investors exceptions that exceed margin  - Get a Liquidity Default Swap By Orion Karl Daley – August 2009 okdaley@gmail.com

  5. Collateral and Liquidity Default Swaps Normal Business Scenario using default swap contract coverage Custodian Lender Loans Securities gets Collateral Default Swap Loans Cash gets Liquidity Default Swap Sec Lending Borrower ( borrows securities ) Insuring Agent Writes Policies for Default Swaps Repo Sell Side ( Borrows Cash ) Rule: For every Sec Lending or Repo Contract issued by the Custodian Lender, a matching Default Swap Policy Contract is purchased from the Insurer. Each Policy Contract is tailored to the specific Custodian Exposure of an issued contract By Orion Karl Daley – August 2009 okdaley@gmail.com

  6. Collateral and Liquidity Default Swaps Covering Defaults using default swap contracts • Insurer Pays Policy Claim to Custodian Lender based on the value of the Swap Contract • Custodian Lender provides long term loan to insurer for the amount of the policy payment at a discount interest rate that is less than the policy cost. Transaction Coverage Benefits: Custodian Lender Receives Coverage from Swap Contract for default Issuing Loans adds additional assets to the balance sheet Insuring Agent Meets obligations by obtaining low cost loan with no impact to reserves Can continue to write Policy Swap Contracts with out increasing exposure By Orion Karl Daley – August 2009 okdaley@gmail.com

  7. Collateral and Liquidity Default Swaps Custodian Lender Overall Benefits: Tactical Mitigation Needs • Assures Mitigation of Defaults through swap coverage • Creates additional assets by providing loans to insurers in order for them to meet their policy coverage(s). Strategic Expansion in Auction and Agency Markets • Market Expansion - lower the cost of the deal for what normally could be seen as a high risk client or off book collateral. • Conduct business with low grade borrowers on the Sec Lending Side and Sellers on the Repo Side by providing an entry point where not normally available.   Other Participant Expansion • Prime Brokers further can leverage their risk with hedge funds with something similar, and managing third party agents can in effect be bonded for a higher grade rating . 

  8. Collateral and Liquidity Default Swaps • Benefits to Insurance Companies and Issuers of Policy Contracts • Ability to Continue to write and develop policy market volume with out affecting reserves. • Create and increase a steady stream of liquidity By Orion Karl Daley – August 2009 okdaley@gmail.com

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