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FRM Part I · FRM Exam Part I · Exchanges and OTC Markets

Total notional outstanding of OTC derivatives is reported as USD 600 trillion, while gross market value is USD 15 trillion and gross credit exposure after netting is USD 3 trillion. A commentator says the market's risk is USD 600 trillion. Which assessment is most appropriate?

Notional overstates risk because it is only a reference for payments, not the amount at stake. Gross market value of USD 15 trillion is 2.5% of notional, and exposure after netting of USD 3 trillion is 0.5%, which better reflect potential credit losses.

  1. ANotional overstates credit exposure; gross market value (2.5% of notional) and exposure after netting (0.5% of notional) better measure potential lossesCorrect
  2. BNotional is the best measure because it is the amount that would be lost if all counterparties defaulted
  3. CGross credit exposure after netting must always exceed gross market value
  4. DGross market value equals notional multiplied by the default probability

Explanation

Notional is only a reference amount for computing payments; the amount at risk is the replacement cost, i.e. market value, reduced by netting. Here 15/600 = 2.5% and 3/600 = 0.5%. Netting reduces exposure, so net exposure cannot exceed gross market value.

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