Answer: Credit Default Swap: Graph shows a bell-shaped curve, peaking around year 2, then declining.

## 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.

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