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FRM Part II · FRM Exam Part II · Future Value and Exposure

When simulating a portfolio containing both equity options and interest rate swaps with the same counterparty, why must the Monte Carlo engine model the dependence between risk factors?

Because trades are netted before the positive part is taken, the exposure distribution depends on how the underlying risk factors move together. Ignoring correlation misstates the variance of the net portfolio value and therefore expected exposure and PFE.

  1. ABecause portfolio netting makes the exposure depend on the joint behaviour of the factors, so ignoring correlation can misstate the exposure distributionCorrect
  2. BBecause correlation affects only the discount factor and not the exposure
  3. CBecause simulated paths for different factors must always be identical
  4. DBecause correlation eliminates the need for revaluation on each path

Explanation

Under a netting agreement trade values are summed before flooring, so the distribution of the net value depends on how factors move together. Ignoring dependence misstates the variance of the net value and thus EE and PFE. Paths need not be identical and revaluation is still required.

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