Netting

What it means

Offsetting positive and negative exposures with the same counterparty so that only the net amount is at risk.

The exam angle

Only reduces exposure where the netting agreement is legally enforceable in the counterparty’s jurisdiction. That enforceability is the whole point.

Where it appears in the syllabus

• Credit Risk Measurement & ManagementFRM Part II · exam weight 20% · Merton and reduced-form models, credit VaR, counterparty risk, CVA, CDOs.
• Financial Markets & ProductsFRM Part I · exam weight 30% · Institutions, market structure, futures, swaps, options, rates, FX, MBS.

See it worked through

• Initial margin and the uncleared margin rules, explainedWho has to post it, how it is sized, and why the phase-in dates matter.

There is also a short video: watch it on YouTube.

Related terms

• Counterparty credit riskThe risk that the other side of a derivative defaults before settling, when the contract has positive value to you.
• Adverse selectionThe problem that arises when the party with better information self-selects into a transaction, leaving the…
• CollateralAssets pledged to secure an exposure, reducing loss if the counterparty defaults.
• Credit default swapA contract in which the buyer pays a periodic premium and receives compensation if a specified borrower suffers a…
• Credit spreadThe extra yield a borrower pays over a risk-free benchmark of the same maturity, compensating for default and…
• Credit valuation adjustmentThe reduction in a derivative’s value to reflect the possibility that the counterparty defaults.