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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A dealer settles FX trades with a counterparty. Each day it pays gross amounts of USD 200 million and receives gross amounts of JPY equivalent to USD 198 million in a different system. The dealer moves to payment-versus-payment (PvP) settlement through a settlement bank that makes each leg conditional on the other. What is the principal effect on the dealer's risk?

PvP removes principal settlement risk because each currency leg is final only if the other leg is final. It does not remove replacement cost risk, since before settlement a default can still leave the dealer with an in-the-money contract that must be replaced at market prices.

  1. AIt removes principal settlement risk on the exchanged amounts but not replacement cost risk before settlementCorrect
  2. BIt removes replacement cost risk but leaves principal settlement risk unchanged
  3. CIt eliminates all counterparty credit exposure on the trades
  4. DIt converts credit risk into market risk because the legs are netted

Explanation

PvP makes final transfer of one currency conditional on final transfer of the other, so a party cannot pay without receiving. The principal at risk during settlement is eliminated. Until settlement date, however, the trade's mark-to-market exposure remains, so replacement risk persists.

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