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FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures

A risk manager notes that for a five-year cross-currency swap with exchange of notionals at maturity, the PFE profile peaks late in the trade's life, whereas for a five-year interest rate swap without notional exchange the profile peaks mid-life and falls towards zero. What best explains the difference in the interest rate swap's profile?

An interest rate swap's exposure profile is hump-shaped because the diffusion effect, rising uncertainty about rates, increases exposure early, while the amortisation effect, fewer remaining cash flows, reduces it later. Together they cause exposure to peak mid-life and decline toward zero.

  1. AVolatility of the underlying rises over time, so exposure always increases until maturity
  2. BExposure first rises as uncertainty in rates grows, then falls as remaining cash flows are paid and the amortisation effect dominatesCorrect
  3. CCounterparty default probability falls over time, reducing the exposure
  4. DCollateral is posted automatically in the later years of the swap

Explanation

For an interest rate swap, the diffusion effect (growing uncertainty) increases exposure early, while the amortisation effect (fewer remaining payments) dominates later, creating a hump. Cross-currency swaps with final notional exchange retain large FX-driven exposure at maturity. Default probability and collateral are not what drive the exposure profile shape.

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