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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A bank models the exposure profile of a single uncollateralised 5-year receive-fixed interest rate swap with a counterparty. Which description best fits the expected exposure (EE) profile over time?

The expected exposure of an interest rate swap is hump-shaped. It rises at first because market uncertainty grows with time, then falls toward zero as remaining payments diminish and maturity approaches. Peak exposure therefore occurs mid-life rather than at inception or maturity.

  1. ARises initially as uncertainty accumulates, then declines toward zero as the swap amortises toward maturityCorrect
  2. BRises steadily and peaks at maturity
  3. CStarts at its maximum and declines linearly to zero
  4. DRemains flat at the notional throughout the life

Explanation

Two effects compete: diffusion increases the spread of possible values over time, while the shrinking number of remaining cash flows reduces the value at risk. The result is a hump-shaped profile peaking around one-third to one-half of the life. A profile peaking at maturity fits a forward or FX instrument without interim payments, not a swap.

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