How Does ‘Collateral’ Function in a Bilateral OTC Derivatives Trade?

In a bilateral OTC derivatives trade, collateral is a security deposit exchanged between the two parties to mitigate counterparty risk. The amount of collateral is typically calculated daily based on the movement in the market value of the derivative, a process known as 'margin call' or 'variation margin.' This ensures that if one party defaults, the other party has assets to cover the loss from replacing the trade.