How does netting reduce Exposure at Default for derivatives portfolios?

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AcadiFi · Accepted Answer

Exposure at Default for derivatives equals the counterparty's current mark-to-market owed to us plus potential future exposure from market moves. Netting agreements (ISDA Master Agreement) allow positive and negative MTMs to offset, dramatically reducing EAD.

Without netting: Broadcast Trading has five derivative positions with counterparty Meridian Bank: interest rate swap +$4.2M, cross-currency swap -$1.8M, equity option +$900k, credit default swap -$2.4M, commodity forward +$1.1M. Total positive exposures sum to $6.2M. That's the uncollateralized pre-netting EAD.

With netting: if the ISDA master covers all five trades, we sum MTMs algebraically: 4.2 - 1.8 + 0.9 - 2.4 + 1.1 = $2.0M. Netting reduces current exposure from $6.2M to $2.0M, a 68% reduction.

For Potential Future Exposure (PFE), Basel provides the add-on formula: add-on = notional * conversion factor, with different conversion factors by trade type and maturity. The netted add-on applies a 40% netting benefit factor: netted add-on = 0.4 * sum of gross add-ons + 0.6 * max(0, net MTM) * ratio. For our example, if gross add-ons total $3.5M, netted add-on = 0.4 * 3.5 + 0.6 * 0 = $1.4M.

Total EAD under netting = current exposure + add-on = 2.0 + 1.4 = $3.4M, versus 6.2 + 3.5 = $9.7M unnetted. Collateral posted further reduces EAD up to the unsecured threshold. For FRM, be prepared to calculate both pre- and post-netting EAD and apply add-on netting benefits.

How does netting reduce Exposure at Default for derivatives portfolios?

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