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FRM Part II · FRM Exam Part II · Credit Risk Management

A risk manager computes the expected exposure profile for a newly originated, uncollateralized 5-year interest rate swap with no initial exchange of principal. Which description best fits the typical shape of its expected exposure over time?

Expected exposure for a par swap is hump-shaped. It rises early because uncertainty about market rates grows over time, then falls toward zero at maturity as fewer remaining cash flows are left to be exchanged, so the amortization effect eventually outweighs the diffusion effect.

  1. AIt rises initially and then declines toward zero as payments amortize and maturity approachesCorrect
  2. BIt rises steadily until maturity because uncertainty accumulates
  3. CIt is highest on day one and then declines linearly
  4. DIt stays constant because the swap starts at zero value

Explanation

Two effects compete: the diffusion effect increases uncertainty in the swap's value over time, while the amortization effect reduces remaining cash flows to be exchanged. Early on diffusion dominates, later amortization dominates, so the profile is hump-shaped and returns to zero at maturity. A steady rise ignores amortization.

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