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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-style master agreement with close-out netting. The hedge fund defaults. Which statement best describes the purpose of the close-out amount calculation?

Close-out netting terminates all trades on default, values each at the close-out date, and combines them into a single net amount owed by one party. This prevents cherry-picking and reduces exposure to the net rather than the gross sum of positive values.

  1. AIt converts all transactions into a single net sum payable by one party, by valuing the terminated trades at the time of defaultCorrect
  2. BIt requires the non-defaulting party to continue performing each trade until its original maturity
  3. CIt allows the non-defaulting party to pay only the trades with negative value and keep the positive ones
  4. DIt fixes each trade's value at its original inception price for settlement

Explanation

Close-out netting terminates all transactions on default and values each, aggregating the values into one net amount. Choice B describes continued performance, which is the opposite of termination. Choice C is cherry-picking, which netting is meant to prevent.

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