Module: | MODULE B: RISK MANAGEMENT
Q292: Consider the following statements regarding forward contracts and swap exposures as Off-Balance Sheet items:
1. Forward exchange contracts are classified as off-balance sheet items, which expose the bank to counterparty credit risk.
2. Interest rate swaps do not involve the exchange of principal amounts, hence they carry zero credit equivalent amount for risk weighting.
3. Under the current exposure method, the credit equivalent amount for derivatives includes both the current replacement cost, and the potential future exposure.
Which of the statements given above is/are correct?
2. Interest rate swaps do not involve the exchange of principal amounts, hence they carry zero credit equivalent amount for risk weighting.
3. Under the current exposure method, the credit equivalent amount for derivatives includes both the current replacement cost, and the potential future exposure.
Which of the statements given above is/are correct?
✅ Correct Answer: C
The correct answer is C. Statement 1 is correct: Forward exchange contracts are classic Off-Balance Sheet (OBS) derivatives.
Because they settle at a future date, the bank is highly exposed to Counterparty Credit Risk (CCR) if the counterparty fails to deliver the agreed currency.
Statement 2 is incorrect: While it is true that Interest Rate Swaps (IRS) typically do not involve the exchange of notional principal (only the net interest difference is exchanged), they absolutely do NOT have a zero Credit Equivalent Amount.
Market rate movements can make the swap highly valuable to the bank, creating significant credit risk if the counterparty defaults.
Statement 3 is correct: Under Basel norms (Current Exposure Method or SA-CCR), the CEA for derivatives is the sum of the Current Replacement Cost (MTM value if positive) plus an "add-on" for Potential Future Exposure (PFE), which estimates how much the risk could grow over the remaining life of the contract.
Because they settle at a future date, the bank is highly exposed to Counterparty Credit Risk (CCR) if the counterparty fails to deliver the agreed currency.
Statement 2 is incorrect: While it is true that Interest Rate Swaps (IRS) typically do not involve the exchange of notional principal (only the net interest difference is exchanged), they absolutely do NOT have a zero Credit Equivalent Amount.
Market rate movements can make the swap highly valuable to the bank, creating significant credit risk if the counterparty defaults.
Statement 3 is correct: Under Basel norms (Current Exposure Method or SA-CCR), the CEA for derivatives is the sum of the Current Replacement Cost (MTM value if positive) plus an "add-on" for Potential Future Exposure (PFE), which estimates how much the risk could grow over the remaining life of the contract.