The Monte-Carlo simulation procedure is also an invaluable tool to assess the maximum potential counterparty credit risk exposure (MPCCRE) associated with OTC derivatives trading books. Your trading book consists of three instruments with the same counterparty,

i.e. three forward contracts with ACME Inc expiring in 3, 6, and 12 months, respectively. The contracts are written on the same source of risk, namely the Japanese Yen (JPY). With the first contract, you will be delivering JPY 2 billion to your client in three months at a rate of CAD 0.0121442 per Yen. With the second contract, you will be delivering of JPY 3 billion to your client in six months at a rate of CAD 0.0121598 per JPY. With the third contract, you will be delivering JPY 3 billion to your client in twelve months at a rate of CAD 0.0121911 per Yen. For simplicity, assume that Canadian and Japanese term structures of spot interest rates are flat at 43.96 and -7.36 basis points per year, respectively. The spot exchange rate (CAD/JPY) is equal to 0.0121287, and the exchange rate's implicit volatility is equal to7.2995%.

A) Using the analytic approach, calculate the maximum potential counterparty credit risk exposure (MPCCRE) associated with each contract on a stand-alone basis, using the 95% confidence level. Under this approach, how much credit would these three instruments use against ACME's credit limit? Please, comment briefly.

B) Using the Monte Carlo approach, simulate the evolution of the exchange rate over the next twelve months and assess your MPCCRE to ACME Inc. over this period for the three forward contracts combined. Simulate 5,000 random exchange rate paths using to the following equation:

St+ t = t(r-q- (2/2))t+ xtx NORMSINV(RAND())

where St is the exchange rate at time t, t is the length of a time step (1/52 year), r is the domestic risk-free interest rate, q is the foreign risk-free interest rate, is the volatility of the exchange rate implied from option prices, and NORMSINV(RAND()) is the combination of MS Excel functions that produces random draws from the standardized normal distribution. Plot the portfolio's MPCCRE profile, at the 95% confidence level, over the next twelve months, and determine the amount of credit used by the three instruments combined.

C) Compare the credit usage estimates from A) and B) and spell out the difference in credit usage between the two methods. Which of these two methods is most suitable to assess credit usage for portfolios of derivatives? Please, discuss briefly.

Answer rating: 100% (QA)

Counterparty Credit Risk Exposure Analysis A Analytic Approach Calculate MPCCRE for each contract Use the BlackScholes formula to calculate the potent... View the full answer