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FRM Part II · FRM Exam Part II · Derivatives

A bank that is a clearing member of a central counterparty (CCP) novates a bilateral interest rate swap to the CCP. Which statement best describes the main effect of novation on the bank's counterparty exposure?

Novation substitutes the CCP as the counterparty to each side of the trade, so the bank's credit exposure to the original counterparty becomes exposure to the CCP. Market risk stays with the bank, and initial and variation margin are still required.

  1. AThe bank's exposure to the original counterparty is replaced by exposure to the CCPCorrect
  2. BThe bank's exposure to the original counterparty is retained and the CCP guarantees it only after default
  3. CAll market risk on the swap is transferred to the CCP
  4. DThe bank no longer needs to post any margin on the swap

Explanation

Novation replaces the original bilateral contract with two contracts, each facing the CCP, so the CCP becomes the buyer to every seller and seller to every buyer. The CCP does not take over the market risk of the position, and margin is still required, so the other options are wrong.

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