LO 25.3: Describe the effectiveness o f netting in reducing credit exposure under

LO 25.3: Describe the effectiveness o f netting in reducing credit exposure under various scenarios.
As we have previously discussed, netting can either reduce exposure to a counterparty or have no effect on exposure, but it can never increase it. We now look at netting in more detail, including the relationship between netting and exposure.
A trading instrument will have a beneficial effect on netting if it can have a negative mark-to-market (MtM) value during its life. For instruments whose MtM value can only be positive during their life, the effect on netting will not be as beneficial. Instruments with only positive MtM values include options with up-front premiums such as equity options, as well as swaptions, caps and floors, and FX options. Other instruments can have negative MtM value during their life; however, there is a greater likelihood that MtM will be positive. These instruments include long options without up-front premiums, certain interest rate swaps, certain FX forwards, cross-currency swaps, off-market instruments, and wrong-way instruments.
Despite these instruments having either only positive or mostly positive MtM values, it may still be worthwhile for an entity to include them under a netting agreement for the following reasons:

Future trades with negative MtM values could offset the positive MtM of these instruments. Inclusion of all trades is necessary for effective collateralization.
Netting is beneficial as it ensures that if these positions need to be unwound in the future
and an offsetting (mirror) trade is required, there will be no residual counterparty risk.
T e r m i n a t i o n F e a t u r e s