20. Bank A, which is AAA rated, trades a 10-year interest rate swap (semi-annual payments) with Bank B, which is rated A-. Because of Bank B's poor credit rating, Bank A is concerned about the 10-year exposure it is going to run because of the swap deal. Which of the following measures help mitigate Bank A's credit exposure to Bank B?

I. Negotiate a CSA with Bank B and efficiently manage the collateral management system

II. Execute the swap deal as a reset swap wherein the swap will be marked to market every six months

III. Execute the swap deal with a break clause in the fifth year

IV. Decrease the frequency of coupon payments from semi-annual to annual

A. I only

B. IV only

C. I, II, III and IV

D. I, II and III

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D is correct. Choices I, II, and III are all measures that help mitigate Bank A’s credit exposure to Bank B. Choice I is correct because negotiating a CSA and getting collateral from the counterparty is an effective way of mitigating credit exposure. Choice II is correct -- in a reset swap since the swap is marked to market every period, the credit exposure we run is only for that period i.e. till the next reset; this implies lesser exposure. Choice III is also correct -- A break clause is always useful since it gives the counterparties an opportunity to assess whether they want to continue for the rest of the term of the swap.

Choice IV is incorrect. Decreasing the frequency of payments increases the credit exposure rather than decreasing it. This is because, more the time for the next payment, greater are the chances for the market rates to move in one counterparty’s favor, thereby increasing its credit exposure to the other counterparty.