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

A dealer closes out a portfolio with a defaulted client during a market panic. Quotes from other dealers are very wide, and the dealer's own funding costs have risen sharply. Which feature of a close-out valuation is most likely to generate dispute after default?

The most likely dispute concerns the discretion in determining replacement cost under stressed conditions. Wide quotes, bid-offer spreads, funding costs and liquidity assumptions all affect the value, and the defaulted party's administrator may challenge them. Netting and termination mechanics are structural and less subjective.

  1. AThe fact that the portfolio is netted into one amount
  2. BThe discretion in determining replacement cost, including bid-offer, funding and liquidity assumptions at the termination dateCorrect
  3. CThe existence of a termination date
  4. DThe use of a governing law clause

Explanation

Close-out amounts rely on estimates of replacement cost or market quotes in stressed conditions. Judgments about quotes, funding, and illiquidity can be contested by the defaulter's administrator. Netting, termination dates and governing law are structural features and not the main valuation uncertainty.

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