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FRM Part II · FRM Exam Part II · Derivatives

A risk manager computes the expected exposure profile for a 5-year uncollateralized receive-fixed interest rate swap against a counterparty. Which description of the typical profile and of potential future exposure (PFE) is most accurate?

A swap's expected exposure is hump-shaped: it rises initially as rate uncertainty accumulates, then declines as fewer payments remain, an amortization effect. Potential future exposure is a high percentile, such as 95% or 99%, of the exposure distribution, so it lies above expected exposure.

  1. AExpected exposure rises steadily until maturity because notional is constant, and PFE equals expected exposure
  2. BExpected exposure is flat because the swap starts at zero value, and PFE is the lowest observed exposure
  3. CExpected exposure is hump-shaped, rising at first as uncertainty grows and then falling as remaining payments amortize, and PFE is a high percentile of the exposure distribution above the expected exposureCorrect
  4. DExpected exposure is highest at inception because of the initial fixed rate, and PFE is the average of exposures

Explanation

A swap starts near zero value. Diffusion of rates raises exposure over time, but the shrinking number of remaining cash flows (amortization effect) pulls it down, producing a hump. PFE is a high quantile (e.g., 95% or 99%) of the exposure distribution, so it exceeds EE. Other options misstate the shape or the PFE definition.

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