What it means
Derivatives create exposures that change every day, and without collateral each party would be trusting the other for the full value of those swings. The credit support annex sits underneath the master agreement and sets out the rules for measuring exposure and moving collateral to cover it.
The two headline terms are the threshold, which is the exposure each party is willing to carry uncollateralised, and the minimum transfer amount, which prevents parties calling each other for trivial sums. Between them these determine how much residual credit risk stays on the table at any moment.
The annex also specifies eligible collateral, the haircut applied to each type, who acts as valuation agent, the timing of calls and the interest paid on cash collateral. Those details look technical but they change the economics of a trade, because posting cash that earns a low rate carries a real funding cost.
Collateral is normally exchanged daily against the mark to market value of the whole portfolio, netted across every trade under the same master agreement. Netting is what makes the arrangement efficient, since a party with a $30,000,000 gain on one swap and a $28,000,000 loss on another collateralises only the $2,000,000 net figure.
For corporates the negotiation is usually about avoiding a CSA altogether or securing a generous threshold, because posting variation margin turns a hedge into a source of cash flow volatility. A company that hedges fuel and then sees prices fall can face large collateral calls at exactly the moment its own trading cash flow is under pressure.
In practice
Real-world examples.
Example
An airline hedging jet fuel signs a CSA with a $10,000,000 threshold so that ordinary price movements do not generate daily collateral calls. Only when the mark to market position moves beyond that level does the airline have to post cash, which keeps routine hedging out of its treasury operations.
Example
Two banks trading interest rate swaps with each other agree a zero threshold and daily exchange of variation margin in cash. Because neither carries any uncollateralised exposure, they can trade in far larger size than their credit limits would otherwise allow.
Example
A utility discovers that its CSA accepts only cash and short dated government bonds as eligible collateral. During a period of rising commodity prices it has to sell part of its investment portfolio to raise eligible assets, and afterwards renegotiates the annex to widen the list.
Formula
Calculation
Required credit support = Exposure - Threshold
Delivery amount = Required credit support - Collateral already held, applied only if that figure exceeds the minimum transfer amount
A dealer values its net derivatives portfolio with a corporate client at a mark to market gain of $12,400,000 in the dealer's favour. The annex sets the client's threshold at $5,000,000, the minimum transfer amount at $500,000 and rounding to the nearest $100,000. The dealer already holds $6,000,000 of collateral from the client.
Required credit support = $12,400,000 - $5,000,000 = $7,400,000.
Delivery amount = $7,400,000 - $6,000,000 = $1,400,000.
That exceeds the $500,000 minimum transfer amount and is already a multiple of $100,000, so the dealer calls for $1,400,000. Once it is delivered the dealer holds $7,400,000 of collateral against a $12,400,000 exposure, leaving exactly the $5,000,000 threshold uncollateralised.
Suppose the portfolio value then falls to $12,100,000. Required credit support drops to $12,100,000 - $5,000,000 = $7,100,000, so the client is owed a return of $7,400,000 - $7,100,000 = $300,000. Because $300,000 is below the $500,000 minimum transfer amount, nothing moves until the swing grows larger.Case study
Seen in the real world.
Calderbrook Energy is an invented power generator used here as an illustrative example of how a credit support annex can bite. In the story Calderbrook hedged three years of gas purchases with a dealer under a CSA carrying a threshold of $2,000,000 and a minimum transfer amount of $250,000.
Gas prices then fell sharply. The hedges were doing their job in economic terms, since the physical gas Calderbrook bought became correspondingly cheaper, but the derivative position moved $18,000,000 against the company on paper. Required credit support was $18,000,000 - $2,000,000 = $16,000,000, and with no collateral posted the entire $16,000,000 had to be delivered in cash within two business days.
The fictional company had the hedge right and the liquidity plan wrong. After the episode Calderbrook negotiated a higher threshold, agreed that letters of credit would count as eligible collateral, and began stress testing its cash position against a 30% adverse price move rather than only the gains and losses on the hedge itself.
Watch out
Common mistakes.
- Signing a CSA without modelling the cash outflow that a large adverse market move would trigger, so a working hedge creates a liquidity crisis.
- Confusing the threshold with the minimum transfer amount, when the first is uncollateralised exposure and the second is simply the smallest size of call.
- Ignoring the interest rate paid on posted cash collateral, which over the life of a long dated trade can be worth more than the pricing that was negotiated so hard.
Questions
People also ask.
Is a credit support annex a separate contract?
No, it is an annex to the master agreement and forms part of the same single agreement, which is what allows exposures to be netted across all trades.
What is the difference between initial margin and variation margin?
Variation margin covers today's mark to market movement, while initial margin is an extra buffer held against the loss that could build up while a defaulted portfolio is being closed out.
Do smaller companies need one?
Not always, since many corporate hedges are done on an uncollateralised basis, but the bank then charges a credit valuation adjustment in the price instead of asking for collateral.
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