Credit Risk Management Practice Exam

How do initial margins typically affect exposure?

1. They increase exposure

2. They may reduce exposure

3. They have no effect on exposure

4. They entirely eliminate exposure

The correct answer is: They may reduce exposure

Initial margins play a crucial role in managing credit risk by providing a financial buffer that helps mitigate potential losses. When a trader enters into a leveraged position, the initial margin is the amount of capital that must be deposited as a guarantee to cover potential losses. By requiring an upfront margin, the exposure to credit risk is effectively reduced because the margin acts as a safeguard against volatility in the underlying asset's price. This reduction in exposure occurs because the margin acts as a commitment of capital that the dealer or clearinghouse can access in the event of a default or significant adverse price movement. Essentially, the margin requirement ensures that the participant has a stake in the trade that can be used to cover losses before they escalate to the point of default. In contrast, if there were no initial margins, the exposure to credit risk would be higher, as positions could be taken without any capital commitment, increasing the likelihood of loss without sufficient collateral to back it. Therefore, while initial margins do not eliminate exposure completely—given that market fluctuations can still lead to losses—they do serve to reduce it by ensuring that there is some level of collateral backed against potential unfavorable price movements.