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

A bank and a counterparty trade under an ISDA Master Agreement with close-out netting. The counterparty defaults, and the bank is the non-defaulting party. Which statement best describes the purpose of the close-out amount calculation?

The close-out amount converts all terminated transactions into one net sum, valued at replacement cost at termination. Positive and negative values are offset, so only a single payment is owed by one party. This prevents cherry-picking and replaces ongoing cash flows with a single claim.

  1. ATo convert all transactions under the agreement into a single net amount payable by one party, based on replacement values at terminationCorrect
  2. BTo allow the non-defaulting party to keep only the transactions that have a positive value to it
  3. CTo preserve each transaction's original cash flow schedule until maturity
  4. DTo fix the amount owed using the notional of each trade at inception

Explanation

Close-out netting terminates all covered transactions and values each at the termination date, usually at replacement cost. The values are summed into one net amount. Cherry-picking (keeping only favorable trades) is exactly what close-out netting prevents, and notional is not the basis for valuation.

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