Credit Risk Management Practice Exam

How does the use of rehypothecation change exposure dynamics?

1. It has no impact on exposure

2. It generally decreases counterparty risk

3. It can increase funding costs

4. It eliminates all collateral needs

The correct answer is: It generally decreases counterparty risk

The correct choice highlights that rehypothecation can generally decrease counterparty risk. Rehypothecation occurs when a financial institution uses collateral that has been pledged by a client for its own purposes, often in the form of borrowing. When rehypothecation is employed effectively, it can lead to a more efficient utilization of collateral, thereby enhancing liquidity in the financial system. By allowing institutions to reuse collateral, they can reduce the need to seek new sources of funding or additional collateral, which in turn can lower the overall exposure in transactions. This can be beneficial as it allows for tighter relationships between counterparties and enables quicker transactions, ultimately decreasing the risk associated with potential default scenarios. In contrast, other options do not accurately represent the typical effects of rehypothecation on exposure dynamics. For example, stating that rehypothecation has no impact on exposure overlooks the nuanced ways it can transform risk management practices. Similarly, saying it can increase funding costs does not capture the essence of how efficient collateral management can actually lower these costs in certain scenarios. Lastly, claiming that it eliminates all collateral needs ignores the fundamental requirement for collateral to manage credit risk effectively, even in a rehypothecation context. Thus, the nuanced understanding that rehypothecation can