FRM Exam Part II · Derivatives

Regulatory Capital for Counterparty Credit Risk Under Basel

Q: How is EAD calculated for derivatives under Basel?

Under SA-CCR, EAD for a netting set is 1.4 × (replacement cost + potential future exposure). Replacement cost is the current loss if the counterparty defaulted, floored at zero after collateral. PFE is a multiplier (between 5% and 1) times the aggregate add-on.

Q: What is the difference between the default risk charge and the CVA charge?

The default risk charge is capital against loss if a counterparty actually defaults, based on EAD and a risk weight. The CVA charge is capital against mark-to-market losses from falls in the counterparty's credit quality before any default. A bank holds both for the same derivative.

Q: Why is the SA-CCR multiplier floored at 5% and capped at 1?

The cap at 1 means the add-on is never increased, even when the trade is in-the-money. The 5% floor means the bank still holds some capital for future exposure, however far out-of-the-money or over-collateralised the netting set is. Between those limits, negative V − C reduces PFE.

Q: What risk weight applies to exposures to central counterparties?

Trade exposures to a qualifying CCP carry a 2% risk weight. Default fund contributions are capitalised by a separate formula based on the CCP's hypothetical capital. If the CCP is not qualifying, the bank treats the exposure like a bilateral exposure with the usual risk weight.

Updated 11 October 2026 · Fact-checked

Regulatory capital for counterparty risk is the capital Basel requires against derivative exposures. Under SA-CCR, exposure at default is 1.4 × (replacement cost + potential future exposure). A separate CVA risk charge covers mark-to-market losses from worsening counterparty credit, and trade exposures to qualifying CCPs get a low risk weight, 2%.

Understand Regulatory Capital for Counterparty Risk

When you hold a derivative with a counterparty, you can lose money in two ways. The counterparty can default while you are owed money. Or its credit quality can fall, which cuts the fair value of your claim even though no default occurs. Basel sets capital for both.

The first piece is default risk capital. You need an exposure at default (EAD) for each netting set, meaning the group of trades that can legally be netted. The current Basel method is the Standardised Approach for Counterparty Credit Risk (SA-CCR). It builds EAD from two parts: replacement cost (RC), what you would lose if the counterparty defaulted today, and potential future exposure (PFE), an add-on for how much the exposure could grow. EAD is then multiplied by a risk weight for the counterparty to get risk-weighted assets (RWA).

The second piece is the CVA risk capital charge. Credit valuation adjustment (CVA) is the market price of counterparty credit risk on derivatives. Under Basel III, banks hold capital against the volatility of CVA, not against default. The framework offers the basic approach (BA-CVA) and the standardised approach (SA-CVA), which needs supervisory approval. Securities financing transactions and transactions cleared through a qualifying CCP are generally outside the CVA charge, unless a supervisor requires otherwise.

The third piece is central clearing. A qualifying CCP (QCCP) is one that meets international standards (CPMI-IOSCO) and is properly supervised. Your trade exposures to a QCCP get a 2% risk weight. Your default fund contribution gets its own capital calculation based on the CCP's hypothetical capital. If the CCP is not qualifying, the exposure is treated like a bilateral exposure with the usual risk weights, and the default fund is treated much more harshly.

For the exam, think in layers: EAD, then risk weight, then CVA, then CCP. Keep the formulas straight and know which items sit inside which charge.

Key formulas to remember

SA-CCR exposure at default: EAD = α × (RC + PFE), with α = 1.4; Calculated per netting set. The 1.4 scaling factor applies to the sum, not just to PFE.
Replacement cost, unmargined netting set: RC = max(V − C, 0); V is the netting set mark-to-market and C is net collateral held. Negative values are floored at zero.
Replacement cost, margined netting set: RC = max(V − C, TH + MTA − NICA, 0); TH is the threshold, MTA the minimum transfer amount and NICA net independent collateral amount. This captures exposure that can arise before the next margin call.
Potential future exposure: PFE = multiplier × AddOn(aggregate); The aggregate add-on is the sum of the add-ons across the five asset classes: interest rate, FX, credit, equity and commodity.
PFE multiplier: multiplier = min{1, 5% + 95% × exp[(V − C) ÷ (2 × 95% × AddOn(aggregate))]}; Never above 1 and never below 5%. It falls when the netting set is out-of-the-money or over-collateralised, which gives credit for excess collateral or negative MtM.
Trade-level add-on (linear trades): AddOn = SF × adjusted notional × supervisory delta × maturity factor; SF is the supervisory factor for the asset class. Delta is +1 for long and −1 for short positions in linear products. Interest rate trades use a supervisory duration in the adjusted notional.
Maturity factor: Unmargined: √(min(M, 1 year) ÷ 1 year), with M floored at 10 business days. Margined: 1.5 × √(MPOR ÷ 1 year); M is remaining maturity and MPOR is the margin period of risk. For unmargined sets, M has a floor of 10 business days and the factor is capped at 1 (a maturity of 1 year or more gives 1). The margined factor uses MPOR, not maturity.
Reduced BA-CVA aggregation: K_reduced = √[(ρ × Σ SCVA_c)² + (1 − ρ²) × Σ (SCVA_c)²], with ρ = 50%. Capital charge = DS × K_reduced, with DS = 0.65. Stand-alone CVA: SCVA_c = (1 ÷ α) × RW_c × Σ (M_NS × EAD_NS × DF_NS), with α = 1.4; SCVA_c is the stand-alone CVA capital for counterparty c. In the first term you add up the SCVA values and then square the total. In the second term you square each SCVA_c first and then add them up. ρ = 50% is the supervisory correlation between a counterparty's credit spread and the systematic factor, which is why the first term is the systematic part and the second the idiosyncratic part. In SCVA_c, RW_c is the supervisory risk weight for the counterparty's sector and credit quality. The sum runs over the netting sets NS with that counterparty, using each netting set's effective maturity M_NS, its EAD and a supervisory discount factor DF_NS. DS = 0.65 is the supervisory discount scalar applied to K_reduced. Do not confuse it with the 1.4 in SCVA_c, which divides rather than multiplies.
Risk weights for CCP exposures: Clearing member trade exposures to a QCCP: 2%. Client exposures (through a clearing member): 2% if the specified conditions are met, otherwise 4%; The 2% for client exposures needs the conditions to be met. Broadly, the client must be protected from losses of the clearing member and the CCP. If they are not met, the weight is 4%. Default fund contributions are capitalised by a separate formula. Exposures to non-qualifying CCPs are treated as bilateral exposures, and their default fund exposures get a much harsher treatment.

How to solve Regulatory Capital for Counterparty Risk questions

Use this order for any question on regulatory capital for counterparty risk. It stops you mixing up the separate charges.

1Identify the charge being asked about: default risk EAD (SA-CCR), CVA risk, or CCP exposure. Many wrong answers come from using the wrong charge.
2For SA-CCR, define the netting set and find V (net mark-to-market) and C (net collateral). Check whether it is margined or unmargined.
3Compute RC. Use max(V − C, 0) for unmargined. For margined, include the TH + MTA − NICA term and take the largest of the three.
4Compute the add-on: supervisory factor × adjusted notional × delta × maturity factor for each trade, then aggregate by asset class and in total.
5Compute the multiplier from V, C and the aggregate add-on. Cap it at 1 and floor it at 5%. Then PFE = multiplier × aggregate add-on.
6Compute EAD = 1.4 × (RC + PFE). Apply the counterparty risk weight to get RWA. Capital is RWA × the required ratio.
7For CVA questions, check that the trades are in scope. Exclude QCCP-cleared and securities financing trades unless told otherwise. Then name the approach, BA-CVA or SA-CVA.
8For CCP questions, decide whether the CCP is qualifying. Then apply 2% to trade exposure, or standard bilateral treatment if not qualifying. Check separately for default fund capital and segregated margin.

Quickest way: Four-line SA-CCR shortcut for multiple-choice questions

When to use it: Use it when the question gives V, C, an add-on and a multiplier or enough data to find it, and you have about two minutes.

Write RC = max(V − C, 0) and set RC to zero if V − C is negative (EAD is still 1.4 × PFE, not zero).
Check the multiplier: if V − C ≥ 0 it is 1. The formula gives exactly 1 when V − C = 0 and more than 1 when V − C > 0, so the cap applies. If V − C < 0, compute 5% + 95% × exp[(V − C) ÷ (1.9 × AddOn)].
PFE = multiplier × AddOn, then EAD = 1.4 × (RC + PFE).
Scan the options. Eliminate any answer that omits the 1.4, uses a multiplier above 1, or has a negative RC.

Common mistakes in Regulatory Capital for Counterparty Risk

Leaving out the 1.4 alpha, or applying it only to PFE.
Students remember 'EAD = RC + PFE' from the older current exposure method, or from the general definition of exposure.
Fix: Write EAD = 1.4 × (RC + PFE) every time. The brackets matter.
Letting RC go negative when the netting set is out-of-the-money.
RC is treated like a plain mark-to-market value instead of a loss if the counterparty defaults now.
Fix: Always apply the floor of zero: RC = max(V − C, 0), or the three-way maximum for margined sets.
Using a PFE multiplier above 1.
The exponential formula can return values above 1 when V − C is positive, and students forget the cap.
Fix: The multiplier is capped at 1 and floored at 5%. Positive V − C means a multiplier of exactly 1.
Applying the CVA capital charge to trades cleared through a QCCP.
Students assume CVA applies to every derivative.
Fix: Remember that QCCP-cleared trades and securities financing transactions are generally excluded from the CVA charge, unless the supervisor requires them in.
Mixing up the 2% QCCP risk weight with default fund capital.
Both relate to CCP exposures, so students treat them as one number.
Fix: The 2% applies to trade exposures. Default fund contributions use a separate formula tied to the CCP's hypothetical capital.
Using maturity for the margined maturity factor.
The unmargined formula uses remaining maturity, so students apply it to margined sets too.
Fix: For margined sets the maturity factor is 1.5 × √(MPOR ÷ 1 year). Look for MPOR in the question.

Worked examples

Example 1

A bank has one unmargined netting set with a single counterparty: a 1-year USD/EUR forward with notional USD 10 million, long position. Mark-to-market V = +USD 200,000 and no collateral is held. Use a supervisory factor of 4% for FX, a supervisory delta of +1 and a maturity factor of 1. Compute the SA-CCR EAD and, assuming a 50% counterparty risk weight, the RWA.

Show the solution

RC = max(V − C, 0) = max(200,000 − 0, 0) = USD 200,000.
Add-on = SF × notional × delta × MF = 4% × 10,000,000 × 1 × 1 = USD 400,000. This is the only trade, so the aggregate add-on is USD 400,000.
Multiplier: the exponent is 200,000 ÷ (2 × 0.95 × 400,000) = 200,000 ÷ 760,000 = 0.2632. exp(0.2632) ≈ 1.301, so 0.05 + 0.95 × 1.301 ≈ 1.286, which is above 1. The cap applies, so multiplier = 1.
PFE = 1 × 400,000 = USD 400,000.
EAD = 1.4 × (200,000 + 400,000) = 1.4 × 600,000 = USD 840,000.
RWA = 840,000 × 50% = USD 420,000.

Answer: EAD = USD 840,000 and RWA = USD 420,000. At an 8% ratio this requires USD 33,600 of capital.

Example 2

Using the same forward and an aggregate add-on of USD 400,000, the mark-to-market is now V = −USD 300,000 with no collateral. Compute RC, the multiplier, PFE and EAD.

Show the solution

RC = max(−300,000 − 0, 0) = 0, because the bank would not lose anything if the counterparty defaulted now.
Multiplier exponent: (V − C) ÷ (2 × 0.95 × AddOn) = −300,000 ÷ 760,000 = −0.3947.
exp(−0.3947) ≈ 0.6738. Multiplier = 0.05 + 0.95 × 0.6738 = 0.05 + 0.6401 = 0.6901, which lies between 5% and 1, so no cap applies.
PFE = 0.6901 × 400,000 ≈ USD 276,060.
EAD = 1.4 × (0 + 276,060) ≈ USD 386,500.

Answer: RC = 0, multiplier ≈ 0.69, PFE ≈ USD 276,060 and EAD ≈ USD 386,500. This is lower than the USD 560,000 you would get with a multiplier of 1 (1.4 × 400,000), showing the credit given for negative mark-to-market.

Exam tips

Questions usually test one piece, such as RC, the multiplier or the 1.4 factor. Identify which, then calculate only that piece.
Watch the wording on margining. If you see threshold, MTA, NICA or MPOR, use the margined formulas.
Know exactly what is outside the CVA charge: QCCP-cleared trades and securities financing transactions generally. Conceptual options often hinge on this.
Know the core numbers cold: α = 1.4, multiplier floor 5%, QCCP trade exposure risk weight 2%, ρ = 50% in reduced BA-CVA.
For interpretation questions, say what the measure captures. SA-CCR EAD covers default, CVA capital covers mark-to-market losses from credit deterioration, and the two do not overlap.

Practice questions from Derivatives

Regulatory Capital for Counterparty Risk: frequently asked questions

How is EAD calculated for derivatives under Basel?

Under SA-CCR, EAD for a netting set is 1.4 × (replacement cost + potential future exposure). Replacement cost is the current loss if the counterparty defaulted, floored at zero after collateral. PFE is a multiplier (between 5% and 1) times the aggregate add-on.

What is the difference between the default risk charge and the CVA charge?

The default risk charge is capital against loss if a counterparty actually defaults, based on EAD and a risk weight. The CVA charge is capital against mark-to-market losses from falls in the counterparty's credit quality before any default. A bank holds both for the same derivative.

Why is the SA-CCR multiplier floored at 5% and capped at 1?

The cap at 1 means the add-on is never increased, even when the trade is in-the-money. The 5% floor means the bank still holds some capital for future exposure, however far out-of-the-money or over-collateralised the netting set is. Between those limits, negative V − C reduces PFE.

What risk weight applies to exposures to central counterparties?

Trade exposures to a qualifying CCP carry a 2% risk weight. Default fund contributions are capitalised by a separate formula based on the CCP's hypothetical capital. If the CCP is not qualifying, the bank treats the exposure like a bilateral exposure with the usual risk weight.