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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

A bank holds OTC contracts with a single counterparty: Trade A has a market value of +USD 12 million to the bank, and Trade B has -USD 7 million to the bank. Both fall under a legally enforceable netting agreement. If the counterparty defaults, ignoring collateral and recoveries, what is the bank's credit exposure, and how does it compare with no netting?

With enforceable netting the exposure is USD 5 million, the net of 12 and -7. Without netting the bank would still owe on the negative trade but claim the full positive value, so exposure is USD 12 million. Netting reduces credit exposure by USD 7 million.

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

Explanation

With netting, exposure is max(12 - 7, 0) = 5 million. Without netting, the bank must pay on the negative trade yet only claims the positive one, so exposure is 12 million. Netting reduces exposure by 7 million.

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