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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

A dealer has 12 bilateral swap trades with a counterparty. Under a legally enforceable netting agreement, the trades' current mark-to-market values to the dealer sum to +USD 30 million for the 7 in-the-money trades and -USD 22 million for the 5 out-of-the-money trades. The counterparty defaults. Ignoring collateral and recoveries, what is the change in the dealer's credit exposure resulting from netting compared with no netting, and what is the exposure with netting?

With enforceable netting, exposure equals the net value of 30 minus 22, or USD 8 million, versus USD 30 million without netting. The exposure therefore falls by USD 22 million, because the dealer's amounts owed on losing trades offset its gains upon the counterparty's default.

  1. AExposure falls by USD 22 million to USD 8 millionCorrect
  2. BExposure falls by USD 8 million to USD 22 million
  3. CExposure falls by USD 30 million to zero
  4. DExposure is unchanged at USD 30 million because defaulting parties can cherry-pick

Explanation

Without netting, the dealer's exposure is the sum of positive values, USD 30 million, since it still owes the negative trades. With netting, exposure is max(30 - 22, 0) = USD 8 million. The reduction is 30 - 8 = USD 22 million. Cherry-picking is what netting prevents.

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