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FRM Exam Part II · Counterparty Risk and Beyond

Netting, Collateral and Margining in Counterparty Risk

Updated 11 October 2026 · Fact-checked

Netting, collateral and margining cut counterparty exposure. Close-out netting combines all trades with a defaulter into one net claim. Collateral under a CSA covers that claim. Variation margin tracks current value; initial margin covers moves during the margin period of risk. To solve questions, net first, subtract collateral, then add the risk of the gap period.

Understand Netting, Collateral and Margining

Counterparty exposure is what you would lose if a counterparty defaults while owing you money. For a single derivative, exposure is the larger of its value to you and zero: max(V, 0). If the value is negative, you owe the counterparty and have no credit exposure on that trade.

Close-out netting applies when many trades sit under one legally enforceable master agreement, such as an ISDA Master Agreement. On default, all trades are terminated and valued. Positive and negative values are added into one single net amount. Without netting, the defaulter's administrator could demand payment on trades that owe you nothing and pay you only a fraction on trades that favour you. This is called cherry picking. Netting exposure = max(sum of values, 0), which is never above the sum of the individual max(V, 0) values. Netting is only reliable if the law of the relevant jurisdiction supports it. Banks usually need legal opinions for this.

Collateral is an asset posted to cover exposure. A Credit Support Annex (CSA) sets the terms: which assets are eligible, haircuts on them, the threshold (exposure you accept unsecured), the minimum transfer amount (MTA) (smallest call that is actually made), and how often margin is called. Variation margin (VM) is exchanged as the mark-to-market changes. It resets the exposure to roughly the threshold. Initial margin (IM) is posted at the start as a buffer against losses that arise after the last VM exchange and before close-out. It is not changed by daily value moves to the same degree. IM is often segregated so that it is protected if the receiver fails.

Collateral never removes exposure completely, because of the margin period of risk (MPOR). This is the time between the last margin exchange that the defaulter met and the point when the position is closed out and hedged. During it, the portfolio value can move and no collateral arrives. Regulatory MPOR under Basel is often 10 business days for daily-margined OTC netting sets, and longer for illiquid collateral, large netting sets or disputes. Longer MPOR means larger residual exposure, roughly in proportion to the square root of MPOR under a normal model.

Collateral brings its own risks. Its value can fall (hence haircuts). It can be correlated with the counterparty's credit quality (wrong-way risk). Receiving it can create liquidity demands, and reusing it (rehypothecation) can expose you to the other party's failure.

Key formulas to remember

Exposure without netting
Exposure = Σ max(Vi, 0)
Each trade is treated alone. Only positive values count.
Exposure with close-out netting
Net exposure = max(Σ Vi, 0)
Valid only if netting is legally enforceable. Always ≤ the no-netting figure.
Net-to-gross ratio (NGR)
NGR = max(Σ Vi, 0) ÷ Σ max(Vi, 0)
Ranges from 0 to 1. Lower means more netting benefit.
Collateralised exposure
Exposure after collateral = max(Net exposure − Collateral held, 0)
Collateral held should be after haircuts. Add any unsecured amount from the threshold.
Haircut value
Collateral value = Market value × (1 − haircut)
Haircuts cover price and FX moves of the collateral asset.
CSA call amount
Call = Net exposure − Threshold − Collateral held (made only if ≥ MTA)
Where the call is positive. Rounding rules may also apply.
Exposure over the margin period of risk
Residual exposure ≈ max(V(t) + ΔV over MPOR − Collateral, 0)
Under a normal model the std dev of ΔV scales with √MPOR.

How to solve Netting, Collateral and Margining questions

Use this order for any numerical or conceptual question on netting and collateral.

  1. 1Check enforceability. If the question says netting is not enforceable, treat each trade separately.
  2. 2List all trade values in the netting set from your point of view. Positive means they owe you.
  3. 3Compute gross exposure (sum of positives) and net exposure (max of the sum, 0). Find NGR if asked.
  4. 4Apply collateral terms: haircut the collateral, then subtract it from the net exposure. Floor at zero.
  5. 5Apply CSA terms: threshold first, then check whether the call exceeds the MTA.
  6. 6Consider the MPOR: ask what could change in value before close-out, and whether IM covers it.
  7. 7State the interpretation: what remains is residual exposure, and name the risks left (MPOR, wrong-way, collateral value, legal).

Quickest way: Net, collateralise, then ask what moves

When to use it: Use in timed MCQs with trade values, a threshold or an MPOR.

  1. Add all trade values. If the sum is negative, net exposure is zero.
  2. Subtract collateral held after haircut. Floor at zero.
  3. For call questions, subtract threshold from exposure, then compare with MTA.
  4. For conceptual options, pick the one that links IM to MPOR gap risk and VM to current mark-to-market.
  5. Eliminate any option that says netting or collateral removes all risk.

Common mistakes in Netting, Collateral and Margining

  • Netting trades without checking legal enforceability.

    Students treat netting as automatic arithmetic.

    Fix: Netting works only under an enforceable master agreement and jurisdiction. Without it, use the sum of positive values.

  • Including negative trade values in gross exposure.

    Mixing up gross and net.

    Fix: Gross exposure sums only positive values. Net exposure sums all values and then floors at zero.

  • Confusing initial and variation margin.

    Both are called margin and both are collateral.

    Fix: VM follows current mark-to-market and is exchanged repeatedly. IM is a buffer for future moves over the MPOR and is typically segregated.

  • Applying the MTA or threshold in the wrong order or ignoring them.

    Students call the full exposure every time.

    Fix: Call = exposure − threshold − collateral held. If the result is below the MTA, no transfer happens.

  • Assuming daily margining means zero exposure.

    Forgetting the gap between the last margin and close-out.

    Fix: Always consider MPOR. Value can change during it, so residual exposure remains.

  • Forgetting to haircut non-cash collateral.

    Taking market value as the collateral value.

    Fix: Multiply by (1 − haircut) before offsetting exposure.

Worked examples

Example 1

A bank has three trades with one counterparty under an enforceable ISDA netting agreement. Values to the bank are +USD 12 million, +USD 5 million and −USD 9 million. Calculate gross exposure, net exposure and the net-to-gross ratio.

Show the solution
  1. Gross exposure = sum of positives = 12 + 5 = USD 17 million.
  2. Net sum = 12 + 5 − 9 = USD 8 million, which is positive, so net exposure = USD 8 million.
  3. NGR = 8 ÷ 17 = 0.4706, about 47%.

Answer: Gross exposure USD 17 million; net exposure USD 8 million; NGR about 0.47.

Example 2

Net exposure to a counterparty is USD 20 million. The CSA has a threshold of USD 4 million and an MTA of USD 0.5 million. The bank holds USD 14 million of collateral (after haircut). What call is made, and what exposure remains if the counterparty then defaults immediately and the call was met?

Show the solution
  1. Call = 20 − 4 − 14 = USD 2 million.
  2. The call of 2 is above the MTA of 0.5, so it is made.
  3. After the call is met, collateral held = 14 + 2 = USD 16 million.
  4. Exposure after collateral = 20 − 16 = USD 4 million, which equals the threshold.

Answer: The bank calls USD 2 million. Residual exposure is USD 4 million, the threshold, before any value change over the margin period of risk.

Exam tips

  • Read for the word 'enforceable'. It decides whether you net.
  • Do the arithmetic in the order: net, haircut, threshold, MTA.
  • For concept questions, link IM to MPOR and VM to current value. This is the most testable distinction.
  • Reject any option claiming collateral or netting eliminates counterparty risk.
  • Know that a longer MPOR raises residual exposure, and that disputes or illiquid positions lengthen it.

Practice questions from Counterparty Risk and Beyond

Netting, Collateral and Margining in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Netting, Collateral and Margining: frequently asked questions

How does close-out netting reduce exposure?

It replaces many trade-level claims with one net claim on default. Negative-value trades offset positive ones, so exposure is max(sum of values, 0). This avoids cherry picking.

What is the difference between initial margin and variation margin?

Variation margin moves with the current mark-to-market and is exchanged regularly. Initial margin is an upfront buffer sized for potential losses over the margin period of risk. IM is often segregated.

What is the margin period of risk?

It is the time from the last margin exchange the defaulter met until the position is closed out and hedged. Value can change in this window with no collateral arriving. A longer period means more residual exposure.

What do threshold and minimum transfer amount mean in a CSA?

The threshold is the exposure you accept without collateral. The MTA is the smallest margin call that will actually be made. Both leave some exposure uncollateralised.