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

Following a counterparty default, a bank needs to determine the close-out value of a long-dated swap. Markets are illiquid and the bank's own funding spread has widened sharply. Which issue is most relevant to the valuation under a close-out amount approach that reflects replacement cost?

A replacement-based close-out lets the non-defaulting party reflect the cost of replacing the trade, including wide bid-offer spreads and its own funding and credit costs. In illiquid markets this creates valuation uncertainty and potential disputes over the claim, rather than using a fixed last mid-market mark.

  1. AThe close-out value may include the cost of replacing the trade, so wide bid-offer spreads and the surviving party's funding and credit costs can increase the claim and cause disputesCorrect
  2. BThe close-out value must be set equal to the last mid-market mark before default regardless of conditions
  3. CThe close-out value must exclude any hedging and funding costs to be enforceable
  4. DThe close-out value is fixed by the defaulter's liquidator at the original contractual rate

Explanation

Replacement-based close-out allows the non-defaulting party to reflect what it would cost to replace the trade, including market illiquidity and funding costs. This makes valuation subjective and a source of dispute. Last mid-market marks are not mandated.

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