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FRM Part II · FRM Exam Part II · Credit Risk

A bank has a USD 100 million, 5-year interest rate swap with a counterparty. Which description best fits the expected exposure profile over the life of the swap, assuming a flat curve at inception?

An interest rate swap shows a hump-shaped exposure profile. Early on, rising uncertainty about rates increases potential exposure, but as payments are exchanged the remaining life shortens and exposure falls toward zero at maturity. So exposure rises, peaks mid-life, then declines.

  1. AExposure is highest at inception and declines linearly to zero
  2. BExposure rises initially, peaks at an intermediate time, then declines toward zero as payments amortizeCorrect
  3. CExposure is constant because the notional is fixed
  4. DExposure rises steadily and is highest at maturity

Explanation

For a swap, uncertainty about rates grows with time, which increases potential exposure, but remaining payments shrink (amortization effect). The two effects produce a hump-shaped profile peaking at roughly one-third to one-half of life. The maturity-peak profile fits a forward or an FX-type contract with a single final exchange, not a coupon swap.

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