Question 15.5: A four-year interest rate swap currently has a negative valu...

Risk Management and Financial Institutions

A four-year interest rate swap currently has a negative value to a financial institution. Is the financial institution exposed to credit risk on the transaction? Explain your answer. How would the capital requirement be calculated under Basel I?

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There is some exposure. If the counterparty defaulted now, there would be no loss. However, interest rates could change so that at a future time the swap has a positive value to the financial institution. If the counterparty defaulted at that time, there would be a loss to the financial institution. The capital under Basel I would, from Table 15.2, be 0.5% of the swap’s principal.

Table 15.2 Add-On Factors as a Percent of Principal for Derivatives
Remaining Maturity (yr)	Interest Rate	Exchange Rate and Gold	Equity	Precious Metals Except Gold	Other Commodities
<1	0	1	6	7	10
1 to 5	0.5	5	8	7	12
>5	1.5	7.5	10	8	15

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