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FRM Part II · FRM Exam Part II · Counterparty Risk and Beyond

A risk manager reviews a variation-margin agreement with daily margin calls. The counterparty defaults, and the bank's close-out of positions takes 10 days, during which no further collateral is exchanged. Which statement best describes the residual exposure under the agreement?

Residual exposure is the potential change in portfolio value over the margin period of risk, from the last successful margin call until the positions are closed out and replaced. Daily margining shrinks exposure but cannot remove it because values move during this default-to-close-out gap.

  1. AZero, because daily margining fully eliminates exposure
  2. BExposure arising from changes in portfolio value over the margin period of risk, which is roughly the period from the last successful margin call to close-outCorrect
  3. CExposure equal to the full initial mark-to-market, because collateral is ignored after default
  4. DExposure arising only from the threshold amount, since the margin period of risk is irrelevant

Explanation

Daily margining reduces but does not remove exposure. Residual risk is the value change over the margin period of risk, covering the gap between the last margin call and close-out and the time to liquidate or replace trades. Zero exposure is wrong because of this gap; the other options misstate how collateral works.

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