FRM Part I · FRM Exam Part I · Central Clearing
A dealer faces a counterparty with two netting sets. Netting set 1 has a net value of +$14 million to the dealer, and netting set 2 has a net value of -$6 million. The agreements do not allow cross-netting between sets. Each set holds no collateral. The counterparty defaults, and recovery on unsecured claims is 40%. What is the dealer's expected loss, ignoring any amounts it owes on netting set 2 being offset?
The dealer's loss is $8.4 million. With no cross-netting, the claim is the $14 million positive netting set; the -$6 million set cannot reduce it. With 40% recovery, the loss is 60% of 14, or 8.4 million.
- A$8.4 millionCorrect
- B$4.8 million
- C$5.6 million
- D$3.2 million
Explanation
Without cross-netting, the dealer's claim is the positive set only: $14 million. Loss given default is 60%, so loss is 0.6 x 14 = $8.4 million. Using 14 - 6 = 8 would give 4.8, which wrongly allows cross-netting. Using 40% recovery loss (5.6) applies recovery as the loss rate.
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