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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank's simulation of a 5-year interest rate swap with a counterparty shows the expected exposure profile rising initially and then declining to zero at maturity. Which explanation best accounts for this hump-shaped profile?

The hump arises from two opposing effects: diffusion, where uncertainty about rates grows over time and lifts potential exposure, and amortisation, where fewer remaining cash flows reduce the value at risk as payments are made. Amortisation dominates later and drives exposure to zero at maturity.

  1. ADiffusion effect increases uncertainty over time, while the amortisation effect reduces remaining cash flows as payments are madeCorrect
  2. BMargining raises exposure steadily over time because collateral is posted later
  3. CCredit spread widening raises the swap's exposure in each later period
  4. DNetting causes exposures to rise because offsetting trades expire first

Explanation

For a swap, the dispersion of possible market values grows with time (diffusion), but fewer remaining payments reduce the exposure (amortisation). The combination gives a rise then fall to zero. Collateral reduces exposure, and spreads affect default probability, not exposure.

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