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FRM Part I · FRM Exam Part I · Swaps

A bank has entered into a single interest rate swap with a corporate counterparty. Which statement best describes the bank's credit exposure on the swap if the counterparty defaults today?

The bank bears credit loss only when the swap has positive value to it at the time of the counterparty's default. A negative value is a liability the bank still owes, so there is no credit loss. Exposure depends on the swap's value, not on who pays fixed.

  1. AThe bank is exposed only if the swap has a positive value to the bank at the time of defaultCorrect
  2. BThe bank is always exposed, because both parties owe payments under the contract
  3. CThe bank is exposed only if it is the fixed-rate payer, because floating payments are uncertain
  4. DThe bank is exposed only if the swap has a negative value to the bank at the time of default

Explanation

A swap is a two-way contract, so credit loss arises only when the defaulting party owes net value to the other side. If the swap has positive value to the bank, it loses part of that value on default. If the value is negative to the bank, it still owes the amount and suffers no credit loss. Exposure does not depend on whether the bank pays fixed or floating.

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