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

A bank and a hedge fund trade under an ISDA master agreement with a close-out netting provision. The hedge fund defaults. Under the close-out process, what is the primary purpose of determining a single close-out amount?

The close-out amount converts all terminated transactions into a single net sum payable by one party. This replaces gross claims with a net claim and prevents the liquidator from cherry-picking favourable trades, which reduces counterparty exposure on default.

  1. ATo replace all transactions with one net payable or receivable owed by one party to the otherCorrect
  2. BTo allow the bank to cherry-pick profitable trades and continue the loss-making ones
  3. CTo value each trade separately and settle only trades with positive value to the bank
  4. DTo postpone valuation until all trades mature in the normal course

Explanation

Close-out netting terminates all transactions on default, values each, and aggregates the values into one net sum. This reduces exposure to the net amount rather than the gross positive values. Cherry-picking is exactly what close-out netting prevents.

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