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

Which statement best describes how the notional amount outstanding of OTC derivatives relates to the credit exposure of the market's participants?

Notional amount is only a reference for calculating payments, so it overstates risk. Gross market value, and even more so exposure after netting, better measures credit exposure because only the replacement value of contracts owed to a party is lost on default.

  1. ANotional amount equals the maximum loss that dealers could suffer if all counterparties defaulted
  2. BGross market value, and especially exposure net of netting agreements, is a much better measure of credit exposure than notional amountCorrect
  3. CNotional amount is irrelevant because OTC derivatives never create credit exposure
  4. DCredit exposure always exceeds the notional amount because of leverage

Explanation

Notional is only a reference amount for computing payments and is not the amount at risk. Gross market value (replacement cost) and exposure after netting reflect actual credit exposure. Treating notional as the loss overstates risk, since typically only the net positive value is at risk.

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