exercise: credit exposure of a derivative with "add-on" charge

[fullofquestions]

The Basel Accord computes the credit exposure of derivatives using both replacement cost and an “add-on” to cover potential future exposure, which of the following is the correct credit risk charge for a purchased 7 y OTC equity index option of $50m notional with a current mark to market of $15m with no netting and a counterparty weighting of 100%?
a. $1.6m (ANS)
b. $1.2m
c. $150,000
d. $1m

Could someone provide a formula or hint for this question. I have yet to find one. Thanks.

 

[rahul.goyl]

Hi,

The add-on factor is 10%. this gives a credit exposure of $15 +$50* 10% = $20 M, and credit risk charge of $20 * 8% =$1.6M

Hope it helps, I cannot explain the formula, becoz its been recommended by Basel.

Regrads,
Rahul