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FRM Part II · FRM Exam Part II · Credit Risk Management

A bank has two OTC derivative trades with the same counterparty under a legally enforceable netting agreement: Trade A has a mark-to-market value of +USD 12 million and Trade B has -USD 7 million to the bank. No collateral is held. If the counterparty defaults, what is the bank's exposure and what would it be without netting?

Exposure is USD 5 million with netting, since the positive USD 12 million is offset by the negative USD 7 million. Without netting, exposure is USD 12 million, the sum of the positive-value trades only, because negative-value trades cannot reduce the claim on the defaulter.

  1. AUSD 5 million with netting; USD 12 million without nettingCorrect
  2. BUSD 12 million with netting; USD 5 million without netting
  3. CUSD 5 million with netting; USD 19 million without netting
  4. DUSD 7 million with netting; USD 12 million without netting

Explanation

With netting, the exposure is max(12 - 7, 0) = USD 5 million. Without netting, the bank must pay the USD 7 million owed on Trade B in full yet recovers only a fraction of Trade A, so the exposure is the sum of positive values, USD 12 million. Adding absolute values (19) is incorrect.

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