Explanation

Correct Answer: D - Credit Default Swap

Why D is correct:

• Credit Default Swaps (CDS) typically exhibit a bell-shaped PFE profile that peaks in the middle of the contract term
• This pattern occurs because:
  • Early years: Default probability is low, so exposure is minimal
  • Middle years: Default probability increases, leading to higher potential exposure
  • Later years: As the contract approaches maturity, remaining payments decrease, reducing potential exposure
• The peak around year 2 in the described graph aligns with typical CDS exposure patterns

Why other options are incorrect:

A - Fixed Rate Bond: Incorrect - Fixed rate bonds typically have decreasing PFE as time passes, but the described decrease from 120% to 40% is too steep and doesn't match typical bond exposure patterns

B - Cross Currency Swap: Incorrect - Cross currency swaps usually show increasing PFE due to FX risk accumulation, but the described increase from 0% to 30% is too gradual and doesn't capture the typical exposure profile

C - Interest Rate Swap: Incorrect - Interest rate swaps typically exhibit a hump-shaped PFE (increasing then decreasing), not a flat profile. The flat exposure described doesn't match the characteristic exposure pattern of interest rate derivatives

Key Concept: PFE profiles vary by instrument type based on their risk characteristics and cash flow patterns. Understanding these typical shapes is crucial for counterparty credit risk management.