FRM Exam Part II · Netting, Close-out and Related Aspects

Netting and Close-out Netting Basics for FRM Part II

Updated 11 October 2026 · Fact-checked

Netting combines multiple obligations between two parties into one net amount. Close-out netting applies on default: the non-defaulting party terminates all transactions under a master agreement, values each one, and sums the values into a single net claim. Exposure is the larger of the net amount and zero.

Understand Netting and Close-out Netting Basics

Netting means offsetting what two parties owe each other so only one net amount is due. It exists because gross obligations tie up credit lines, capital and liquidity. Settling every trade on its own is costly and risky.

There are two main forms. Payment netting (also called settlement netting) nets payments due on the same day, in the same currency, under the same transaction or agreement. It cuts settlement risk and cash flows. It does not change what happens on a default. Close-out netting works only when a counterparty defaults or another termination event occurs.

Under close-out netting, the non-defaulting party ends all covered transactions early. It values each one at the termination date, with positive values for it and negative values for it as the payer. It adds them up into one net close-out amount. If the net is positive for the non-defaulting party, it becomes an unsecured claim on the defaulter's estate. If the net is negative, it owes that amount to the estate.

Why this reduces exposure: without netting, the insolvent party's administrator could demand payment on trades that are in its favour and leave you as an unsecured creditor on trades that favour you. This is called cherry picking. With enforceable netting, your exposure is max(Σ values, 0), not Σ max(value, 0). Netting never raises exposure, and it lowers it when some trades have negative value.

The key condition is legal enforceability. Banks rely on a master agreement such as the ISDA Master Agreement, where all trades form a single agreement. Netting also needs legal opinions in each relevant jurisdiction. If netting is not enforceable, exposure must be treated on a gross basis.

Key formulas to remember

Exposure without netting (gross): Gross exposure = Σ max(Vi, 0); Vi is the value of trade i to you. Only positive-value trades count; negatives are ignored.
Exposure with enforceable close-out netting: Net exposure = max(Σ Vi, 0); Sum all values in the netting set first, then floor at zero.
Netting benefit: Benefit = Gross exposure − Net exposure; Always ≥ 0. It equals zero when all trades have positive value (or all negative).
Net-to-gross ratio (NGR): NGR = Net exposure ÷ Gross exposure; Lower means more netting benefit. Defined when gross exposure is above zero.
Close-out net amount: Net close-out amount = Σ (close-out values of terminated trades) ± unpaid amounts; Positive means the defaulter owes the non-defaulting party. Negative means the reverse.

How to solve Netting and Close-out Netting Basics questions

Use this method for any question on netting, close-out or exposure reduction.

1Identify the netting set: which trades sit under one enforceable master agreement. Trades under different agreements or non-nettable ones stay separate.
2Check enforceability. If the question says netting is not legally enforceable, compute exposure on a gross basis.
3Write the value of each trade from your point of view. Positive means they owe you; negative means you owe them.
4Compute gross exposure by adding only the positive values.
5Compute net exposure by summing all values in the netting set, then taking max(sum, 0).
6If several netting sets exist, floor each set at zero separately, then add the results.
7State the netting benefit or ratio, and interpret: who has a claim on whom, and what remains unsecured.

Quickest way: Sum, floor, compare

When to use it: Use when the question gives trade values and asks for exposure or netting benefit.

Sum the values inside each netting set.
Floor each set total at zero.
Add the floored sets to get net exposure.
Gross is the sum of positives only. Subtract net from gross for the benefit.
Eliminate options that show net exposure above gross, since that cannot happen.

Common mistakes in Netting and Close-out Netting Basics

Confusing payment netting with close-out netting.
Both use the word netting and both combine amounts.
Fix: Payment netting covers same-day, same-currency payments in normal operation. Close-out netting applies on default and involves termination and valuation of all trades.
Flooring each trade at zero before summing when netting applies.
Students carry over the gross exposure formula.
Fix: Under enforceable netting, sum first, then floor once per netting set.
Netting across different netting sets or agreements.
Students treat all trades with one counterparty as one pool.
Fix: Only trades in the same legally enforceable netting set net. Floor each set separately.
Assuming netting always reduces exposure.
Netting is taught as a benefit.
Fix: Netting never increases exposure, but the benefit is zero if all trades have the same sign.
Ignoring legal enforceability.
Math questions hide the legal condition in the text.
Fix: Read for statements about jurisdiction or legal opinions. If netting is not enforceable, use gross exposure.
Treating a net positive close-out claim as secured.
Students think netting gives protection like collateral.
Fix: Netting only shrinks the claim. Without collateral, the remaining claim is unsecured and recovers at the recovery rate.

Worked examples

Example 1

A bank has three OTC derivatives with a counterparty under one enforceable master agreement. Values to the bank: +USD 12 million, −USD 5 million, +USD 3 million. The counterparty defaults. Find gross exposure, net exposure, and the netting benefit.

Show the solution

Gross exposure = 12 + 3 = USD 15 million (the negative trade is ignored).
Net sum = 12 − 5 + 3 = USD 10 million.
Net exposure = max(10, 0) = USD 10 million.
Netting benefit = 15 − 10 = USD 5 million.

Answer: Gross USD 15 million, net USD 10 million, benefit USD 5 million.

Example 2

A bank has two netting sets with a counterparty. Set A trades have values +USD 8 million and −USD 11 million. Set B trades have values +USD 6 million and −USD 2 million. Both sets are enforceable. Find the total net exposure and the net-to-gross ratio.

Show the solution

Set A sum = 8 − 11 = −3, floored at zero gives 0.
Set B sum = 6 − 2 = 4, floored gives 4.
Net exposure = 0 + 4 = USD 4 million.
Gross exposure = 8 + 6 = USD 14 million.
NGR = 4 ÷ 14 = 0.286, about 28.6%.

Answer: Net exposure is USD 4 million and the net-to-gross ratio is about 28.6%.

Exam tips

Look first for the legal condition. Many questions turn on whether netting is enforceable.
Read whether the question asks for payment netting or close-out netting. The default trigger signals close-out.
Do not net across separate agreements; floor each netting set at zero.
Check that your net exposure is never greater than gross exposure.
Remember a positive net claim is still unsecured unless collateral exists.

Practice questions from Netting, Close-out and Related Aspects

Netting and Close-out Netting Basics: frequently asked questions

What is close-out netting in FRM Part II?

It is the process where, on a counterparty default, all transactions under a master agreement are terminated and valued. The values are summed into one net amount, which is the only claim either side has.

What is the difference between payment netting and close-out netting?

Payment netting offsets same-day, same-currency payments during normal operations and reduces settlement risk. Close-out netting happens on default and nets the termination values of all trades, reducing credit exposure.

How does netting reduce counterparty credit exposure?

Exposure becomes max(sum of values, 0) rather than the sum of positive values. Trades with negative value offset those with positive value, so exposure falls unless all trades have the same sign.

Why does legal enforceability matter?

If a court could allow cherry picking, a bank cannot rely on netting. Regulators then require exposure to be treated on a gross basis, which raises measured exposure and capital.