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

A risk manager reviews the exposure profile of a single uncollateralised, non-netted 5-year interest rate swap in which the bank pays fixed and receives floating, with a flat starting yield curve. Which statement best describes how the expected exposure (EE) profile typically behaves over the life of the swap?

The EE of an interest rate swap is hump-shaped: it rises at first as market uncertainty widens the value distribution, then falls toward zero as remaining cash flows diminish and the swap approaches maturity, so the peak sits at an intermediate time.

  1. AIt rises initially as uncertainty accumulates, peaks at an intermediate point, then declines toward zero as remaining payments shrinkCorrect
  2. BIt is constant over the life because the notional is fixed
  3. CIt declines steadily from inception since cash flows are exchanged
  4. DIt rises steadily and is highest on the final day of the swap

Explanation

Two effects compete: the distribution of the swap's value widens with time (diffusion), while remaining cash flows fall (amortisation). The result is a hump-shaped EE profile peaking in roughly the first third to half of life. A constant or monotonic profile ignores one of these effects.

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