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

A bank holds a 5-year interest rate swap in which it receives fixed and pays floating, with payments exchanged periodically. Which description best fits the shape of its expected positive exposure (EPE) profile over the life of the swap?

An interest rate swap's expected exposure is hump-shaped. Early on, growing uncertainty about rates (diffusion) raises potential value, but as payments are exchanged fewer remaining cash flows are exposed (amortisation), so exposure peaks in the middle and falls toward zero at maturity.

  1. AMonotonically increasing until maturity, because uncertainty about rates always grows with time
  2. BHump-shaped: rising at first as rate uncertainty grows, then declining as remaining payments run off (amortisation effect)Correct
  3. CFlat at the notional amount throughout the life of the swap
  4. DHighest on day one, then declining linearly to zero at maturity

Explanation

For a coupon-bearing swap two forces act. The diffusion effect increases the spread of possible values as time passes, while the amortisation effect reduces the remaining cash flows to be exchanged. Diffusion dominates early and amortisation dominates later, giving a hump shape. The monotonic option ignores run-off.

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