Dear David,
I’ve have struggling with the following question from FRM practice and past exams. Appreciate your kind help on this!
9) On Credit Exposure (FRM handbook 5th edition, Example 21.11 page 515)
Which one of the following deals would have the greatest credit exposure for a $1000000 deal size (assume the counterparty in each deal is an AAA-rated bank and has no settlement risk)?
a. Pay fixes in an Australian dollar interest rate swap for one year
b. Sell SD against AUD in a one-year forward foreign exchange contract
c. Sell a one year AUD cap
d. Purchase a one-year certificate of deposit
Answer provided: d. Purchase a one-year certificate of deposit
My question: I’m a bit undecided between b and d. I understand that for d, the amount in the question represents the nominal value and for b, the amount represents notional value. In normal cases, the credit exposure in a currency forward is much smaller than the notional value due to the movement of the forward prices. However, please excuse me for the stupidity of the following question:
I’m wondering if there is any scenario whereby the currency forward prices moves so much that for the original notional value of $X, 1 times or even n times $X is gained in the contract to one party and is thus exposed to credit risk to its counterparty? For example, 100 JPY/USD for a notional of $1000 forward contracts moves to 200 JPY/USD, contract value increases from JPY 100000 to JPY200000, a change of 100% of original notional value.
Thank you for your enlightenment and correction!
Cheers
Liming
10/11/09
I’ve have struggling with the following question from FRM practice and past exams. Appreciate your kind help on this!
9) On Credit Exposure (FRM handbook 5th edition, Example 21.11 page 515)
Which one of the following deals would have the greatest credit exposure for a $1000000 deal size (assume the counterparty in each deal is an AAA-rated bank and has no settlement risk)?
a. Pay fixes in an Australian dollar interest rate swap for one year
b. Sell SD against AUD in a one-year forward foreign exchange contract
c. Sell a one year AUD cap
d. Purchase a one-year certificate of deposit
Answer provided: d. Purchase a one-year certificate of deposit
My question: I’m a bit undecided between b and d. I understand that for d, the amount in the question represents the nominal value and for b, the amount represents notional value. In normal cases, the credit exposure in a currency forward is much smaller than the notional value due to the movement of the forward prices. However, please excuse me for the stupidity of the following question:
I’m wondering if there is any scenario whereby the currency forward prices moves so much that for the original notional value of $X, 1 times or even n times $X is gained in the contract to one party and is thus exposed to credit risk to its counterparty? For example, 100 JPY/USD for a notional of $1000 forward contracts moves to 200 JPY/USD, contract value increases from JPY 100000 to JPY200000, a change of 100% of original notional value.
Thank you for your enlightenment and correction!
Cheers
Liming
10/11/09
