a little confused …
it can…but probably it’s not the best/most used.
at least it can, but the sample exam 1 said it doesn’t address liquidity risk, bizarre
I was confused with that as well. My thought was as you will need less money for the position, you will have less liquidity risk. But I think I was wrong. For this question I think we should have recalled the very basic definition of risk; i.e. uncertainity. After all you cannot reduce the uncertainity related to the amount of payment, whether you will need to pay or not.
the problem is netting, without netting the liquidity risk can be huge, say you give me $100b, I will give you $99.9999999b, but no netting, if you can’t show me $100b, I will sue you $100m, with netting, I even own you 1 buck, what do you say?
assuming I have $99.9999999b of course
Need for cash and liquidity risk does not equate. Like endowments’ case. They need cash for spending but more or less it is known in advance, so you assume that liquidity is not much of a concern. But for non life insurance there is volatility in earnings and claims, liquidity is a more important concern, which will limit your risk taking ability. So what Iwant to say is liquidity risk is better understood by volatility, uncertainity rather than the amount.
I understand your point, however, with netting, you don’t need to liquidize your stock (let’s say you have $100b worth of stock) for the payment, it can reduce liquidity risk (risk of not being able to sell all, without price impact). I admit it’s indirect though.
Where was this question? Schweser or CFA? I will make up my mind according to the source. If it is CFA, it is like holly book, I will just repent and accept that there is no relevance to liquidity. Otherwise, I guess you have a point.
Netting can reduce your risk…BUT it said the Primary method and that is Reducing Exposure to a single Counterparty. If I had a $1B in netting arrangements with Bear that would suck even though they are ‘netted’, but if I had $1B spread out among 10 different banks then I have just diversified my credit risk…
Netting means you don’t know how much you will have to pay out… That was my lame attempt at squaring that one…