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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 reduces credit exposure when a counterparty enters bankruptcy. Which statement best describes the key legal problem that close-out netting addresses?

Close-out netting prevents cherry picking by the liquidator of a defaulted counterparty. Without it, the estate could enforce trades in its favour and disclaim losing ones, leaving the solvent party exposed to gross amounts. Netting terminates all trades and combines them into a single net payment.

  1. AIt stops the counterparty's liquidator from cherry picking by enforcing only trades that are favourable to the defaulted estateCorrect
  2. BIt guarantees that collateral is always returned to the defaulting party at its original value
  3. CIt removes the need to value the trades after a default
  4. DIt transfers the counterparty's trades to a central counterparty automatically

Explanation

Without netting, a liquidator may honour profitable contracts and repudiate unprofitable ones (cherry picking), leaving the solvent party with gross losses. Close-out netting replaces all trades with a single net amount. It does not remove valuation needs nor involve a CCP transfer.

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