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FRM Part II · FRM Exam Part II · Derivatives

A clearing member of a central counterparty (CCP) wants to understand how novation changes its exposure on a bilateral over-the-counter swap that is cleared. Which statement best describes the effect of novation?

Novation makes the CCP the buyer to every seller and the seller to every buyer. The original bilateral contract is replaced by two contracts facing the CCP, so counterparty credit exposure is transferred to the CCP rather than remaining with the original counterparty.

  1. AThe CCP becomes the buyer to every seller and the seller to every buyer, replacing the original bilateral counterparty exposureCorrect
  2. BThe original counterparties remain liable to each other and the CCP only guarantees the initial margin
  3. CThe CCP nets the trade against the clearing member's uncleared trades with other dealers
  4. DThe CCP removes all market risk from the trade by hedging it with the exchange

Explanation

Novation replaces the original contract with two contracts, each facing the CCP. Counterparty exposure then runs to the CCP rather than to the original counterparty. The CCP does not eliminate market risk for members, and it does not net cleared trades against uncleared trades.

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