Explanation:
Under Basel I, the Credit Equivalent Amount (CEA) for an OTC derivative is calculated as Current Exposure (Replacement Cost) plus Potential Future Exposure (Add-on).
Add-on for a 5-year interest rate swap (falls under 1 to 5 years category) = 0.5% × $100,000,000 = $500,000.
Current Exposure = $4,500,000.
CEA = $4,500,000 + $500,000 = $5,000,000.
Basel I caps the risk weight for OTC derivative transactions at 50%.
Risk-weighted asset (RWA) = $5,000,000 × 50% = $2,500,000.
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Q.41 Family Bank has entered a $100 million interest rate swap with a corporation. The swap has a remaining maturity of five years. The current value of the swap is $4.5 million. The table below gives add-on factors as a percentage of principal for derivatives.
| Time remaining to maturity | Interest rate | Equity |
|---|---|---|
| < 1 year | 0.0 | 6.0 |
| 1 to 5 years | 0.5 | 8.0 |
| > 5 years | 1.5 | 10.0 |
Based on the table above, the equivalent risk-weighted asset (RWA) under Basel I is closest to:
A
$5,000,000
B
$1,125,000
C
$3,500,000
D
$2,500,000
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