Question

In: Finance

A bank has the following transactions with another BBB-rated bank: (i) A three-year interest rate swap...

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?

Solutions

Expert Solution

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

  1. max(2, 0) + 0.5% * $80 million = $2.4 million
  2. max(-4, 0) + 1% * $120 million = $1.2 million
  3. max(6, 0) + 1% * $40 million = $6.4 million

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


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