Explanation:
First, we must convert the notional amounts in EUR to USD using the exchange rate provided:
For Counterparty K: 300 EUR * 1.1 (exchange rate) = 330 USD
For Counterparty L: 200 EUR * 1.1 (exchange rate) = 220 USD
Now, we calculate the net notional exposure in USD:
Net Long position in USD = Notional Amount of Counterparty I + Converted Notional Amount of Counterparty K = 500 USD + 330 USD = 830 USD
Net Short position in USD = Notional Amount of Counterparty J + Converted Notional Amount of Counterparty L = 400 USD + 220 USD = 620 USD
Net notional exposure after compression = Net Long position - Net Short position = 830 USD - 620 USD = 210 USD Long
Counterparty I holds the net contract position after compression because it contributes the largest remaining long position when the positions are expressed in USD.
A is incorrect because it fails to account for the converted EUR positions into USD, which are required to calculate the correct net exposure.
B is incorrect because it states the exposure in EUR and does not convert it to USD, which is necessary to find the net exposure in a common currency.
D is incorrect because the positions do not offset each other even after accounting for the currency conversion; there remains a net long exposure.
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Q.5512 Global Finance Bank (GFB) is in the final stages of implementing a trade compression strategy to reduce its notional exposure in credit derivatives. The risk management team at GFB has outlined a complex scenario involving offsetting Credit Default Swap (CDS) contracts that can be compressed. However, there is a catch: one of the CDS contracts includes a payment leg in a different currency, introducing currency risk into the compression calculation. GFB must calculate the net notional exposure and identify the counterparty that will hold the net contract position after accounting for the currency exchange rate. Here are the details of the CDS contracts before trade compression:
| Reference Entity | Notional Amount | Position | Counterparty | Currency of Payment | Exchange Rate (to USD) |
|---|---|---|---|---|---|
| DEF Index | 500 | Long | Counterparty I | USD | - |
| DEF Index | 400 | Short | Counterparty J | USD | - |
| DEF Index | 300 | Long | Counterparty K | EUR | 1.1 |
| DEF Index | 200 | Short | Counterparty L | EUR | 1.1 |
The current EUR/USD exchange rate is 1.1. After considering the currency exchange rate, what will be GFB's net notional exposure in USD, and which counterparty will hold the net contract position?
A
Net notional exposure of 100 USD Long held by Counterparty I.
B
Net notional exposure of 200 EUR Long equivalent to 220 USD held by Counterparty K.
C
Net notional exposure of 210 USD Long held by Counterparty I after converting EUR to USD.
D
No net notional exposure as the positions across different currencies completely offset each other.