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FRM Part I · FRM Exam Part I · Swaps

A bank has entered into a plain vanilla interest rate swap with a corporate client in which the bank pays fixed and receives floating. Interest rates have since risen sharply, so the swap has a positive value to the bank. Which statement best describes the bank's credit exposure to the client on this swap?

The bank is exposed to the client's default because the swap has a positive value to the bank. Credit loss on a swap arises only when the contract is an asset; the notional is never exchanged, so it is not the exposure, and initial zero value does not protect later.

  1. AThe bank has no credit exposure because the swap was entered into at zero initial value
  2. BThe bank is exposed to the client defaulting, because the swap is an asset to the bankCorrect
  3. CThe bank is exposed to the client defaulting only if rates fall back below the original swap rate
  4. DThe bank's exposure equals the full notional principal of the swap

Explanation

Credit exposure on a swap arises when its value to a party is positive, since the counterparty's default would then cause a loss of that value. A zero initial value does not remove later exposure, and notional is not exchanged, so it is not the amount at risk.

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