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

A risk manager reviews the valuation timing in close-out netting. Which feature is typically a source of valuation risk that makes the close-out amount differ from the pre-default mark-to-market?

Close-out valuation risk arises because trades are terminated and replaced in stressed markets, with wider bid-offer spreads and time delays. These can make the close-out amount differ materially from the last pre-default mark-to-market, and the value is neither fixed at par nor certain.

  1. AClose-out is determined at the time of default so that the netting set's value is fixed with certainty
  2. BTermination and replacement of trades is carried out in stressed markets, with wider bid-offer spreads and delays that can change the valueCorrect
  3. CNetting agreements require all trades to be valued at par on default
  4. DClose-out values are always lower than mid-market values for the non-defaulting party

Explanation

Close-out occurs during stress, with illiquidity, wider spreads and a delay between default and valuation, so realised values can diverge from prior mark-to-market. Value is not fixed with certainty, there is no par rule, and close-out values need not be lower than mid.

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