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FRM Part II · FRM Exam Part II · Future Value and Exposure

A bank holds a 10-year uncollateralized interest rate swap, paying fixed and receiving floating, with a single counterparty. Which description best fits the expected positive exposure (EPE) profile of this swap over its life?

A long-dated interest rate swap has a hump-shaped exposure profile: exposure rises as rate uncertainty accumulates, peaks before the middle of the swap's life, then falls to zero at maturity as remaining cash flows diminish through amortization.

  1. AIt rises steadily and peaks at maturity
  2. BIt is flat at the notional amount throughout the life
  3. CIt rises initially, peaks at around one-third to one-half of the life, then declines toward zero at maturityCorrect
  4. DIt is highest at inception and declines linearly to zero

Explanation

For an interest rate swap, uncertainty about market value grows with time (diffusion effect) while remaining cash flows shrink (amortization effect). The two effects combine to give a hump-shaped profile peaking before mid-life. Exposure at inception is zero for a par swap, so a profile that is highest at inception is wrong.

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