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

A bank's regulator requires standardised OTC interest rate swaps to be cleared through a central counterparty (CCP). Which of the following best describes the primary effect of novation to the CCP on the bank's counterparty exposure?

Novation replaces the bank's bilateral exposure to its original counterparty with exposure to the CCP, which becomes the counterparty to both sides of the trade. Market risk stays with the bank, margin is still required, and the CCP's guarantee is limited by its default resources.

  1. AThe bank's bilateral exposure to its original counterparty is replaced by exposure to the CCPCorrect
  2. BThe bank's market risk on the swap is transferred to the CCP
  3. CThe bank no longer needs to post any collateral on the swap
  4. DThe bank's exposure becomes zero because the CCP guarantees all trades without limit

Explanation

Under novation, the CCP becomes the buyer to every seller and the seller to every buyer, so the original bilateral contract is replaced by two contracts with the CCP. The bank keeps its market risk but now faces the CCP. Collateral is still required through initial and variation margin, and the CCP's guarantee is limited by its default resources.

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