Skip to content

FRM Part II · FRM Exam Part II

Derivatives Counterparty Risk for FRM Part II

In FRM Part II, derivatives counterparty risk sits within the Credit Risk Measurement and Management topic, not a separate Derivatives chapter. You measure exposure (EE, PFE, EPE), reduce it with netting and collateral, price it through CVA and DVA, and assess wrong-way risk, CCPs, credit derivatives and capital. Name the metric, apply the method, then interpret the result.

What this chapter covers

This chapter is about the credit risk you carry when a derivative counterparty can default while the trade has positive value to you. Unlike a loan, the exposure is uncertain and changes with market moves. So the chapter starts with how to measure exposure, then moves to how to cut it, price it and regulate it.

The topics build on each other. Exposure metrics come first. Netting and collateral change those metrics. CVA and DVA turn exposure into a price. Wrong-way and right-way risk explain when the simple models fail. Central clearing, credit derivatives and capital rules show how the market and regulators respond.

The chapter links closely to the rest of the paper. It uses credit risk ideas such as probability of default, loss given default and spreads. It uses market risk tools such as simulation and volatility. It also connects to liquidity risk through margin calls and collateral demands, and to current issues such as stress in non-bank financial institutions.

Questions here are applied and often case-like, so they reward candidates who understand the logic and not only the formulas. The same ideas keep returning: exposure profiles, the effect of netting and collateral, the CVA approximation, and the role of CCPs. If you can name the measure, run the method and explain the result, you can pick up reliable marks across Credit Risk, Market Risk and Liquidity topics. A solid grasp also makes other chapters easier.

Derivatives: topics in the order to study them

  1. 1Counterparty Risk and Credit Exposure MetricsStart here because every later topic reuses exposure terms such as current exposure, EE, PFE and EPE.
  2. 2Netting, Collateral and Credit MitigantsNext, see how netting agreements and margin reduce the exposure you just learned to measure.
  3. 3Credit Valuation Adjustment (CVA) and DVANow convert exposure, default probability and loss given default into a price adjustment.
  4. 4Wrong-Way and Right-Way RiskStudy it after CVA, since it shows when assuming independence between exposure and default understates loss.
  5. 5Central Counterparties and ClearingClearing builds on netting, collateral and default risk, so it makes sense once those are clear.
  6. 6Credit Derivatives: CDS and Credit-Linked ProductsCDS are both a hedge for counterparty risk and a source of it, so learn them after CVA and clearing.
  7. 7Regulatory Capital for Counterparty RiskFinish with Basel capital rules, which draw on every earlier idea.

How to prepare Derivatives

Aim to understand the chain from exposure to price to capital. Practise with short applied questions, because the exam is multiple choice and scenario based.

  1. Read the exposure metrics and draw the exposure profile of a swap and of an option. Note why they differ in shape over time.
  2. Work two or three small netting examples by hand. Compare gross and net exposure, and see when netting does not help.
  3. Learn the CVA approximation: CVA ≈ LGD × Σ (discounted EE × marginal default probability). Practise it on a three-period example.
  4. Make a short list of wrong-way risk cases, such as a bank buying CDS protection on a sovereign from a bank in that same country, and explain the direction of the effect.
  5. Compare bilateral and cleared trading in a table you write yourself: margin types, default fund, loss waterfall and risks of concentration.
  6. Learn the Basel counterparty capital terms exactly, including CVA capital and default risk capital, and avoid mixing them.
  7. Finish with timed sets of 10 questions. For every miss, write one line on whether you erred on the concept, the formula or the reading of the question.

Common mistakes in Derivatives

  • Treating exposure as the full trade value, including negative values.

    Fix: Always apply max(V, 0) first, and only then average or take percentiles.

  • Confusing EE, EPE and PFE.

    Fix: Remember that EE is an average at one date, EPE averages over time, and PFE is a high percentile.

  • Assuming netting and collateral always remove exposure.

    Fix: Check for legal enforceability, thresholds, transfer amounts and the margin period of risk before choosing an answer.

  • Getting the sign of DVA wrong.

    Fix: Think of it as the mirror of CVA: it is the counterparty's view of its expected loss on you, and it rises when your spread widens.

  • Ignoring dependence between exposure and default.

    Fix: When a question links the trade to the counterparty's fortunes, state that wrong-way risk makes simple CVA too low.

  • Claiming central clearing eliminates counterparty risk.

    Fix: Say that clearing moves and mutualises risk, and that the CCP's own resilience, margin procyclicality and concentration remain concerns.

Last-day revision: Derivatives

  • Counterparty risk on derivatives is examined within the Credit Risk Measurement and Management topic; there is no separate Derivatives topic in the six Part II topics.
  • Current exposure = max(V, 0), where V is the trade's mark-to-market value to you.
  • Expected exposure (EE) is the average positive exposure at a future date; EPE is the time average of EE. Regulatory capital uses effective EPE, based on non-decreasing effective EE, averaged over the first year, or until the maturity of the longest-dated contract in the netting set if all contracts mature within a year.
  • PFE is a high percentile of the exposure distribution at a future date, so at a high confidence level it is typically larger than EE at the same date.
  • Netting applies only where it is legally enforceable, and it can only reduce exposure, never increase it.
  • Collateral reduces exposure but leaves a gap from the margin period of risk, thresholds and minimum transfer amounts.
  • CVA is the market value of expected counterparty credit loss; DVA reflects your own default risk and gives a gain when your credit worsens.
  • CVA rises with higher exposure, higher default probability and higher loss given default.
  • Wrong-way risk means exposure rises as the counterparty's credit quality falls; right-way risk is the opposite.
  • A CCP becomes the buyer to every seller and the seller to every buyer, and it uses initial margin, variation margin and a default fund.
  • A CDS buyer pays a periodic premium and receives protection on default, so the buyer is short credit risk.
  • CDS protection bought from a weak seller carries counterparty risk and may carry wrong-way risk.
  • Basel capital for counterparty risk includes a default risk charge and a separate CVA risk charge.

Derivatives practice questions

Derivatives in other exams

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

Derivatives: frequently asked questions

Where does derivatives counterparty risk sit in FRM Part II?

It is covered within the Credit Risk Measurement and Management topic. There is no separate Derivatives chapter among the six Part II topics. It covers exposure metrics, netting, collateral, CVA and DVA, wrong-way risk, central clearing, credit derivatives and regulatory capital, and ties to market and liquidity risk.

Do I need to memorise formulas for this chapter?

You need a few core ones, such as current exposure and the CVA approximation, and you must understand what drives each term. Most questions test interpretation, so know the direction of each effect, not only the arithmetic.

How is this chapter tested in the 80-question exam?

Expect applied multiple-choice questions, often short scenarios. You may need to pick the right exposure measure, judge the effect of a netting or margin change, or explain a CVA or wrong-way result.

Where should I begin if counterparty risk is new to me?

Begin with exposure metrics and draw exposure profiles for a swap and an option. Once you see how exposure changes through time, netting, collateral and CVA are much easier to follow.