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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank has a single uncollateralised OTC interest rate swap with a corporate client. The swap currently has a negative mark-to-market value to the bank of USD 3 million. If the client defaults today, with no netting or collateral, what is the bank's current exposure on this trade?

The current exposure is zero. Counterparty exposure is the larger of the contract's market value and zero, and a negative value means the bank owes money to the client. Default by the client therefore creates no credit loss on this trade today.

  1. AUSD 3 million
  2. BZeroCorrect
  3. CUSD 3 million plus the potential future exposure
  4. DNegative USD 3 million, which the bank recovers from the client

Explanation

Current exposure equals the greater of the mark-to-market value and zero. The bank owes the client USD 3 million, so it has no claim to lose on default. Choosing USD 3 million confuses the bank's liability with its credit exposure.

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