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

A non-defaulting party calculates a close-out amount by obtaining mid-market valuations for terminated trades, but its policy requires adjustments for the cost of replacing the positions. Which adjustment is most consistent with a replacement-cost close-out valuation?

The party should include bid-offer spreads and hedging costs it would incur to replace the terminated trades. Replacement-cost close-out reflects the real cost of restoring the economic position, so mid-market values or inception prices understate or misstate the loss to the non-defaulting party.

  1. AUsing mid-market values with no bid-offer adjustment because the trades were originally priced at mid
  2. BIncluding the bid-offer spread and hedging costs the party would incur to replace the terminated tradesCorrect
  3. CUsing the original trade prices at inception
  4. DUsing the defaulting party's credit spread to discount all trades

Explanation

Replacement cost reflects what the surviving party must pay to re-establish its position, so transaction costs such as bid-offer and hedging are included. Inception prices are stale, and mid-market ignores replacement frictions. Using the defaulter's spread is not the replacement-cost basis.

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