# Hull RMFI - EOC 15 Question 21 - Credit Equivalent Amount

#### PJAYAKUMAR

##### Member

R64.P2.T7.Hull_Ch15,16,17

Page 24

15.21. A bank has the following transaction with a AA-rated corporation a) A two-year interest rate swap with a principal of $100 million that is worth$3 million b) A nine-month foreign exchange forward contract with a principal of $150 million that is worth –$5 million c) A long position in a six-month option on gold with a principal of $50 million that is worth$7 million What is the capital requirement under Basel I if there is no netting? What difference does it make if the netting amendment applies? What is the capital required under Basel II when the standardized approach is used? Using Table 12.2 the credit equivalent amount under Basel I (in millions of dollars) for the three transactions are a) (a) 3 + 0.005 × 100 = 3.5 b) (b) 0.01 × 150 = 1.5 c) (c) 7 + 0.01 × 50 = 7.5 The total credit equivalent amount is 3.5 + 1.5 + 7.5 = 12.5. Because the corporation has a risk weight of 50% for off-balance sheet items the risk weighted amount is 6.25. The capital required is 0.08 × 6.25 or $0.5 million. If netting applies, the current exposure after netting is in millions of dollars 3 − 5 + 7 = 5. The NRR is therefore 5/10 = 0.5. The credit equivalent amount is in millions of dollars 5 + (0.4 + 0.6 × 0.5) × (0.005 × 100 + 0.01 × 150 + 0.01 × 50) = 6.75 The risk weighted amount is 3.375 and the capital required is 0.08 × 3.375 = 0.27. In this case the netting amendment reduces the capital by 46%. Under Basel II when the standardized approach is used the corporation has a risk weight of 20% and the capital required is$0.108 million.

Hello David - Can you please explain the calculation on Credit equivalent amount for both netting and without netting? Sorry I am not able to follow the calculation

As example
The credit equivalent amount is in millions of dollars 5 + (0.4 + 0.6 × 0.5) × (0.005 × 100 + 0.01 × 150 + 0.01 × 50) = 6.75

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#### tom87

##### Member
Hi @PJAYAKUMAR ,

Hull has the following formula to compute the credit equivalent amount taking bilateral netting into account:

I don't know how the 0.4 and 0.6 coefficients were derived but that's the formula.

In the question, NRR=0.5 so
credit equivalent amount = max(0,3-5+7)+(0.4+0.6*0.5)*(0.005*100+0.01*150+0.01*50) = 6.75

Hope that helps