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What is collateral yield?

  • This topic has 4 replies, 2 voices, and was last updated 1w by gontata.
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    • gontata
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      Collateral yield is the return on your collateral in a forward contract. But what collateral is usually used and where does the yield come from?

      I get collateral and roll/convenience yield ‘on paper’, that is, to the point that I know enough that I can get questions right most of the time. But I need a bit of help understanding on a conceptual level how this works.

      Any explanation, example of even thoughts would help!

    • Zee Tan
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      It’s not just on forward contracts, but any commodities derivatives, such as forwards, futures, swaps. Collateral yield is one of the components of return, along with roll or convenience yield, and the return from the change in spot price (spot price return or spot return).

      When you enter into a long or short position of financial instruments such as derivatives, you’re often required to post margin, which is an asset that you have to deposit with your counterparty to cover some, or all of the credit risk you pose to your counterparty. The assets you post as margin is your collateral.

      The most common form of collateral for derivatives are cash or securities like US Treasury Bills (T-bills). This collateral generates interest income, which will then be reflected in the derivative’s price, hence a collateral yield.

    • gontata
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      But does that mean that although you deposit T-bills as collateral with the counterparty, and the counterparty holds it, you collect the interest in it? How would it work if it’s cash?

      Sorry to potentially ask a stupid question…

    • Zee Tan
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      There are no stupid questions! 😀

      The collateral’s yield is reflected in the derivative’s price. This means that the future/forward/swap’s price is affected by the fact that the collateral posted will generate a yield, be it T-bill coupons or cash earning a risk-free rate.

      So whether it’s T-bills or cash, the collateral yield is often assumed to be the risk-free rate.

    • gontata
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      That makes sense – thanks.

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