Credit Risk Management Practice Exam

How does trade compression benefit trading parties in credit risk management?

1. Increases the risk profile

2. Reduces net exposure without altering overall risk

3. Ensures all trades are profitable

4. Eliminates the need for trading partners

The correct answer is: Reduces net exposure without altering overall risk

Trade compression is a process that involves consolidating multiple trades into fewer transactions, effectively reducing the number of outstanding contracts between trading parties. The primary benefit of trade compression in credit risk management is that it reduces net exposure without altering the overall risk profile. By compressing trades, firms can lower their counterparty exposure as they eliminate redundant positions, which helps in minimizing the credit risk that arises from having multiple open trades with the same counterpart. This reduction in net exposure to a counterparty can lead to lower capital charges and, ultimately, reduce the potential impact of a counterparty default. It preserves the effective market positions while making them more manageable and transparent, leading to a cleaner balance sheet. The other options focus on elements that do not accurately reflect the benefits of trade compression, such as increasing risk or ensuring profitability. Eliminating the need for trading partners inaccurately suggests that relationships between parties would no longer be necessary, which contradicts the fundamental nature of financial markets. Therefore, the focus on how trade compression enables a reduction in net exposure while maintaining the same overall level of risk accurately captures the beneficial aspect of this practice in credit risk management.