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FRM Part II · FRM Exam Part II · Netting, Close-out and Related Aspects

A bank trades derivatives with a corporate under a single master agreement that contains a legally enforceable close-out netting provision. The corporate then defaults. Which description best captures the effect of close-out netting on the bank's claim?

Close-out netting terminates all transactions under the master agreement upon default and combines their values into one net amount owed by one side. This prevents cherry-picking by the defaulter's administrator and reduces the bank's claim to the net position.

  1. AAll transactions are terminated and replaced by one net amount payable by one party to the otherCorrect
  2. BEach transaction is settled separately, and only positive-value trades are paid
  3. CThe bank may choose to keep profitable trades alive and terminate only losing trades
  4. DCollateral is returned to the defaulter before any valuation of transactions takes place

Explanation

Close-out netting terminates all covered transactions on default, values them, and combines the values into a single net sum owed by one party. Cherry-picking (settling only favourable trades) is exactly what netting is designed to prevent, so the other descriptions are wrong.

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