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

A bank has three OTC derivative trades with a single counterparty under a legally enforceable master netting agreement with close-out netting. The trade values to the bank are +40 million, -15 million and +10 million. If the counterparty defaults, what is the bank's exposure (before collateral)?

The exposure is 35 million. Under enforceable close-out netting, all trade values are combined into one net claim: 40 minus 15 plus 10 equals 35 million. Summing only the positive trades gives 50 million, which ignores the offset the netting agreement permits.

  1. A35 millionCorrect
  2. B50 million
  3. C65 million
  4. D0

Explanation

Close-out netting sums all trade values into one net amount: 40 - 15 + 10 = 35 million. Without netting, the bank would owe 15 million to the estate but still claim 50 million (sum of positives), which is the 50 million distractor. The 65 million figure wrongly adds absolute values.

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