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

A bank holds a 5-year uncollateralized interest rate swap, paying fixed and receiving floating, with no netting. Which description best fits the shape of its expected positive exposure (EPE) profile over the life of the swap?

The swap's exposure profile is hump-shaped: it rises at first because rate uncertainty accumulates, then falls toward zero as fewer cash flows remain to be exchanged. The diffusion effect dominates early and the amortization effect dominates later, so exposure peaks mid-life.

  1. AIt rises monotonically to a maximum at maturity
  2. BIt is constant over the life because the notional is constant
  3. CIt rises initially, peaks at an intermediate point, then declines toward zero as maturity approachesCorrect
  4. DIt is highest today and falls linearly to zero at maturity

Explanation

For an interest rate swap, uncertainty about market rates grows with time, which raises exposure, but the remaining number of cash flow exchanges falls, which reduces it (amortization effect). The two effects produce a hump-shaped profile peaking at roughly one-third to one-half of the life. A monotonic rise is characteristic of FX forwards, not swaps.

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