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

A dealer faces a counterparty under an ISDA master agreement. Trades have values to the dealer of +12, +7, -9 and -4 (millions). Legal opinion confirms netting is enforceable in the counterparty's jurisdiction. The counterparty defaults and the recovery rate on unsecured claims is 40%. What is the dealer's expected loss on the close-out, ignoring collateral?

With enforceable netting, the net claim is 12 + 7 - 9 - 4 = 6 million. At a 40% recovery, the loss is 60% of that, or 3.6 million. Applying recovery to gross positive values would wrongly ignore netting benefits.

  1. A3.6 millionCorrect
  2. B6.0 million
  3. C11.4 million
  4. D7.6 million

Explanation

Net value = 12 + 7 - 9 - 4 = 6 million owed to the dealer. Loss = 6 x (1 - 0.40) = 3.6 million. The 6.0 million option ignores recovery. The 11.4 million option applies recovery to gross positives (19 x 0.6) without netting. The 7.6 million option applies a 40% loss to gross positives (19 x 0.4).

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