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

A risk manager explains why close-out netting is important when a counterparty becomes insolvent. Which statement best captures the key legal function of close-out netting in this setting?

Close-out netting terminates all covered transactions on default and collapses their values into one net payable amount. This stops the liquidator from cherry picking profitable trades, so the non-defaulting party's claim is limited to the net exposure rather than gross positive values.

  1. AIt terminates all transactions on default and replaces them with a single net amount payable, which prevents cherry pickingCorrect
  2. BIt lets the defaulting party choose which trades to continue performing after insolvency
  3. CIt removes the need for any collateral to be posted by either party
  4. DIt guarantees the non-defaulting party receives full recovery on all positive-value trades

Explanation

Close-out netting terminates all covered trades upon default and combines their values into one net sum, so the liquidator cannot selectively perform trades. It does not remove the need for collateral, does not guarantee full recovery of gross positive values, and the defaulter cannot choose trades.

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