Explanation:
B is correct. Netting means that the payments between the two counterparties are netted out, so that only a net payment has to be made. With netting, the investment firm is not required to make every payout, hence the loss will be reduced to: USD 32 million + USD 12 million – USD 16 million – USD 8 million = USD 20 million. Without netting, the loss is the outstanding long position: USD 32 million + USD 12 million = USD 44 million.
Learning Objective: Describe the effectiveness of netting in reducing credit exposure under various scenarios.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital, 4th Edition (West Sussex, UK: John Wiley & Sons, 2020). Chapter 6, Netting, Close-out, and Related Aspects
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| Position | Exposure (USD) |
|---|---|
| Long swaptions | 32 million |
| Long credit default swaps | 12 million |
| Long currency derivatives | -16 million |
| Long futures contracts | -8 million |
If the investment company defaults, what would be the loss to the financial institution if netting is used compared to the loss if netting is not used?
A
Loss of USD 20 million if netting is used; loss of USD 24 million if netting is not used
B
Loss of USD 20 million if netting is used; loss of USD 44 million if netting is not used
C
Loss of USD 24 million if netting is used; loss of USD 32 million if netting is not used
D
Loss of USD 20 million if netting is used; loss of USD 24 million if netting is not used
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