The daily change in the mark-to-market value of Swapco's portfolio serves as the
basis for the second component of Swapco's collateral formula. Specifically, the "sen-
sitivity collateral" is determined by the computed potential movement in mark-to-mar-
ket exposure to SBHC over the termination period. Assuming valuation occurs in a
worst-case eight days, the cushion is designed to protect against an improbably large
change in the value of Swapco's portfolio over an eight-day period. The higher of two
measures of standard deviation is used, one of which depends on volatility over a
comparatively long period of time, and the other weighs recent behavior more heavily.
An upward adjustment is made at times when the size of the portfolio changes rapidly.
Over the sample period, the collateral cushion proved sufficient to absorb changes in
the mark-to-market value of the portfolio on nearly all occasions (or all occasions, if a
relatively rapid termination is assumed). In those cases when the cushion proved inad-
equate, the magnitude of the violation was relatively small.
Because equity transactions appear to be associated with somewhat greater volatility,
Swapco uses a two-tier approach in connection with its exposure to equity transac-
tions. If the notional amount of Swapco's equity transactions are within certain defined
limits, the equity portfolio will be incorporated into Swapco's global book, and the usual
collateral test will apply. Beyond such limits, Swapco's equity transactions would be
evaluated as a segregated portfolio and would be subject to a separate collateral
cushion. Swapco's total sensitivity collateral would then equal the sum of the equity
and nonequity cushions. That procedure, by removing the benefit of diversification in
calculating the portfolio's standard deviation, will almost inevitably lead to a larger
overall collateral cushion. Furthermore, the collateral cushion for the equity book, con-
sidered separately, will be equal to a larger multiple of the potential eight-day change
in market-to-market value than in the case of the nonequity book. The additional collat-
eral that would be required by a larger equity book offsets the risk that equity volatility
could produce a large breach of the conventionally calculated collateral cushion.
It is important to understand that a failure of the collateral cushion to absorb changes
in mark-to- market value is not tantamount to a default. Rather, should the collateral
cushion prove insufficient during the termination process, Swapco's capital will be
available to cover the shortfall. Moody's believes that the likelihood of collateral and
capital--considered jointly--failing to protect Swapco's counterparties during termina-
tion is extremely remote and is consistent with the Aaa counterparty rating of Swapco.
Even if Swapco has sufficient resources to meet its obligations during a termination,
there must be a means of assuring liquidity, in that Swapco must be protected against
the risk that it lacks immediate cash to pay claims. Swapco assures sufficient liquidity
by stipulating in each Master Agreement with its counterparties that should a termina-
tion occur, Swapco's receivables will be processed before its payables. Liquidity is fur-
ther enhanced by the practice of investing Swapco's capital in Aaa-rated, marketable
securities. Finally, a decline in Swapco's cash or cash equivalents below a threshold
level would--subject to a cure period--be considered a termination trigger and would
therefore lead to the liquidation of Swapco's book within a short period of time.