In: Finance
A bank has the following transactions with another BBB-rated bank:
(i) A three-year interest rate swap with a principal of $80 million that is worth $2 million.
(ii) A two-year foreign exchange forward contract with a principal of $120 million that is worth –$4 million.
(iii) A long position in a seven-year option on silver (i.e. precious metal other than gold) with a principal of $40 million that is worth $6 million.
(a) What is the capital requirement under Basel I if there is no netting?
(b) What difference does it make if the netting amendment applies?
(c) What is the capital required under Basel II when the standardized approach is used?
Solution to part (a)
Basel I without netting
max(V, 0) + aL
Add-On Factors as a Percent of Principal for Derivatives
Remaining Maturity (yr) |
Interest Rate |
Exchange Rate and Gold |
Equity |
Precious Metals Except Gold |
Other Commodities |
<1 |
0.0 |
1.0 |
6.0 |
7.0 |
10.0 |
1 to 5 |
0.5 |
5.0 |
8.0 |
7.0 |
12.0 |
>5 |
1.5 |
7.5 |
10.0 |
8.0 |
15.0 |
Total = $10 million ($2.4 million + $1.2 million + $6.4 million)
Add-on for corporations when considering off-balance sheet items: 0.5. Thus, $10 million * 0.5 = $5 million are the Risk Weighted Assets. The total Capital Requirement according to Basel I without netting is $5 million * 8% = $400,000
Solution to part (b)
Basel with netting
NRR =
+ (0.4 +0.6 * NRR)
NRR = [2 + (-4) + 6] / 2 + 0 + 6 = 0.5
RWA: 0.5 * ($4 million + (0.4 + 0.6 * 0.5) * (0.5% * $80 million + 1% * $120 million + 1% * $40 million) = $2.7 million
Consequently, Total Capital Requirement under Basel I with netting is $2.7 million * 8% = $216,000
Solution to part (c)
Basel 2 – Standardized approach
AAA to AA- |
A+ to A- |
BBB+ to BBB- |
BB+ to BB- |
B+ to B- |
Below B- |
Unrated |
|
Country* |
0 |
20 |
40 |
80 |
80 |
120 |
80 |
Banks** |
20 |
40 |
40 |
80 |
80 |
120 |
40 |
Corporations |
20 |
40 |
80 |
80 |
120 |
120 |
80 |
*Includes exposures to the country’s central bank.
**National supervisors have options as outlined in the text.
As our corporations has a BBB- rating, we apply the weight of 20% to it. Thus 8% * (20% * $10 million) = $160,000 is the total capital requirement without netting. Applying the netting results in 8% * (20% * $5 million) = $80,000
Basel I |
Basel II |
||
Without netting |
With netting |
Without netting |
With netting |
$400,000 |
$216,000 |
$160,000 |
$80,000 |