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FRM Part II · FRM Exam Part II · Netting, Close-out and Related Aspects

A bank has three derivatives with a defaulted counterparty under an enforceable netting agreement, with close-out values to the bank of +USD 14 million, -USD 6 million and +USD 4 million. No collateral is held. The counterparty's recovery rate is 40% on unsecured claims. What is the bank's loss?

The net close-out claim is USD 12 million (14 - 6 + 4). With 40% recovery, the bank loses 60% of that, which is USD 7.2 million. Using gross positive values of 18 million would ignore netting and overstate the loss at 10.8 million.

  1. AUSD 7.2 millionCorrect
  2. BUSD 10.8 million
  3. CUSD 4.8 million
  4. DUSD 12.0 million

Explanation

Net close-out claim = 14 - 6 + 4 = 12 million. Loss = 12 x (1 - 0.40) = 7.2 million. Applying recovery to the gross positives (18) would give 10.8, which ignores netting.

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