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Conditionally Cancelled: Credit Risk - Forwards, Swaps, and Similar Contracts
Credit Risk Exposure: A Special Attention Area
In a bid to strengthen financial stability, regulators have introduced new guidelines for calculating credit risk exposure related to forwards, swaps, and similar derivative contracts. This article provides an overview of the new framework.
Treatments for Different Instruments
Forwards, swaps, purchased options, and similar derivative contracts are treated differently depending on their characteristics. For example:
- Interest Rate Contracts: Single-currency interest rate and basis swaps, forward rate agreements, interest rate futures, and options receive a special treatment.
- Foreign Exchange Rate Contracts: Cross-country interest rate swaps, forward foreign exchange contracts, currency futures, and options are treated similarly to gold contracts.
- Precious Metals (Other than Gold) Contracts: Such as those involving platinum or silver, are weighted differently based on the category of counterparty.
Netting Arrangements
Banks can apply for netting arrangements to reduce their credit risk exposure. To qualify, a bank must demonstrate that it has:
- A Legally Enforceable Contract with its counterparties.
- Written and Reasoned Legal Opinions from reputable law firms confirming the validity of the netting arrangement under relevant laws.
- Procedures in Place to review changes in relevant laws.
Risk Weighting
Credit equivalent amounts are weighted based on the category of counterparty, similar to on-balance sheet items. For example:
- 0%: Cash, guarantees, or government securities.
- 20%: Securities issued by multilateral development banks.
- 50%: Local government guarantees.
Add-ons and Notional Amounts
The add-on amount is calculated based on the notional principal amount of the contract. In cases where the notional amount is leveraged or enhanced, the bank must use the effective notional amount to ensure accurate calculations.
Conclusion
Regulators have introduced new guidelines for calculating credit risk exposure related to forwards, swaps, and similar derivative contracts. Banks must carefully review these guidelines and adjust their risk management strategies accordingly to maintain financial stability.
Note: This article is conditionally cancelled, meaning that it may be updated or removed at any time without notice.