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

A bank has a single uncollateralized OTC interest rate swap with a corporate client. The swap currently has a mark-to-market value of -USD 4 million to the bank (the bank owes the client). If the client defaults today, what is the bank's current exposure on this trade?

The current exposure is zero. Counterparty exposure equals the larger of the trade's mark-to-market value and zero, so a negative value to the bank means the bank owes money and has no credit claim on the defaulting client.

  1. AUSD 4 million, because the bank must pay the full amount to the client
  2. BUSD 0, because the bank has no claim and exposure is floored at zeroCorrect
  3. CUSD -4 million, because losses on the swap offset recovery
  4. DUSD 2 million, being half of the absolute value of the mark-to-market

Explanation

Current exposure is the greater of the mark-to-market and zero. With a value of -USD 4 million to the bank, the bank would not lose on the client's default, so exposure is max(-4, 0) = 0. Reporting USD 4 million confuses the bank's liability with its credit exposure.

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