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FRM Part II · FRM Exam Part II · Margin (Collateral) and Settlement

A bank pays EUR 50 million to a counterparty in Frankfurt in the morning and is due to receive USD 55 million from the same counterparty in New York later that day, because the two legs settle in different time zones through separate systems. The counterparty fails after the bank's euro payment becomes irrevocable but before the dollar payment arrives. Which risk has the bank suffered?

The bank has suffered Herstatt, or cross-currency settlement, risk. It paid its euro leg irrevocably while the counterparty failed before delivering the dollar leg, so the full principal of one leg is at risk, not merely the replacement cost of the trade.

  1. AHerstatt (cross-currency settlement) riskCorrect
  2. BWrong-way risk
  3. CReplacement cost risk on a netted portfolio
  4. DMargin period of risk

Explanation

The bank delivered one currency leg without receiving the other because the legs settled at different times. This principal exposure is Herstatt risk. Replacement cost risk concerns the loss of unrealised gains before settlement, not the loss of the full principal paid out.

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