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

A bank has two derivative trades with a counterparty that enters insolvency. Trade A has a positive value to the bank of 8 million and Trade B has a negative value to the bank of 5 million. There is no enforceable netting agreement, and the liquidator can enforce contracts that benefit the insolvent estate while disclaiming those that do not. What is the bank's most likely outcome, a practice known as cherry picking?

Without enforceable netting, the liquidator can cherry pick. The bank must still pay the 5 million it owes on the losing trade, while its 8 million gain is only an unsecured claim recovered at a fraction. Netting would reduce the exposure to a net 3 million.

  1. AThe bank pays 5 million in full and recovers only a fraction of the 8 millionCorrect
  2. BThe bank receives 3 million, the net amount, in full
  3. CThe bank pays nothing on Trade B and recovers 8 million in full on Trade A
  4. DThe bank pays 13 million to the estate to settle both trades

Explanation

Without enforceable netting the liquidator keeps the trade that is out of the money for the estate (Trade B, where the bank owes 5 million) and disclaims the one where the estate owes the bank. The bank must pay 5 million in full but only claims 8 million as an unsecured creditor and recovers a fraction. Netting would have limited the exposure to 3 million.

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