FRM Part II · FRM Exam Part II · Central Clearing
A bank and a hedge fund agree a bilateral interest rate swap that is then submitted for clearing at a central counterparty (CCP). After the CCP accepts the trade, the original contract between the bank and the hedge fund is extinguished and replaced by two contracts. Which description best captures this process and its effect?
The process is novation: the original bilateral trade is extinguished and replaced by two trades, each with the CCP as counterparty. The CCP becomes buyer to every seller and seller to every buyer, so the original parties no longer face each other's default risk directly.
- ANovation, with the CCP becoming the buyer to every seller and the seller to every buyerCorrect
- BNetting by close-out, with the CCP guaranteeing only the bank's side of the trade
- CRehypothecation, with the CCP reusing the hedge fund's collateral as its own capital
- DAssignment, with the hedge fund remaining the direct counterparty of the bank
Explanation
In central clearing the original bilateral contract is replaced through novation by two contracts, each facing the CCP. The CCP is therefore the buyer to every seller and the seller to every buyer. The other options describe different mechanisms or leave the original counterparty relationship in place.
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