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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 counterparty. Market quotes for one illiquid exotic trade are unavailable and bid-offer spreads on the hedges have widened sharply. Which approach to the close-out valuation is most consistent with the ISDA 2002 Close-out Amount standard?

The ISDA 2002 Close-out Amount allows the non-defaulting party to use commercially reasonable procedures giving a commercially reasonable result, drawing on quotes or internal models and including replacement and hedging costs. Stale mid-market values or the defaulter's own valuation do not reflect close-out costs in stressed markets.

  1. AUse the mid-market value from the last pre-default valuation date
  2. BDetermine the amount using commercially reasonable procedures to produce a commercially reasonable result, which may use quotes or internal models, including the cost of replacement and hedge unwindCorrect
  3. CUse the defaulting party's own valuation of the trade, as it knows the trade best
  4. DValue the trade at its notional amount to avoid disputes

Explanation

The 2002 ISDA standard lets the determining party use commercially reasonable procedures, with market quotes or internal data, and include replacement and hedging costs. A stale mid-market value ignores the cost of closing out in stressed markets. Using the defaulter's valuation is not the standard.

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