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FRM Part I · FRM Exam Part I · The Governance of Risk Management

A bank's board-approved RAS caps tier 1 leverage exposure growth at 5% and single-name exposure at 10% of capital. Capital is USD 2,000 million. A business head proposes a USD 260 million exposure to one counterparty, arguing that USD 60 million would be fully hedged with a credit default swap from a weaker, highly correlated protection seller. Which conclusion is best?

Reject as proposed. The single-name cap is 10% of USD 2,000 million, or USD 200 million, and the USD 260 million exposure exceeds it. The hedge cannot be fully credited because the protection seller is weaker and highly correlated, creating wrong-way risk needing independent review.

  1. AApprove, since net exposure is USD 200 million, exactly at the limit, and hedges always count in full
  2. BReject as proposed: gross exposure exceeds the USD 200 million cap, and the hedge's wrong-way/correlation risk means it should not be fully credited without risk function reviewCorrect
  3. CApprove, since a limit is only binding when it is breached by more than 25%
  4. DReject solely because leverage growth is capped at 5%

Explanation

The cap is 10% × 2,000 = USD 200 million. The USD 260 million proposal exceeds it by USD 60 million. Netting the hedge assumes full credit, but a weaker, highly correlated protection seller creates wrong-way risk, so the benefit should be assessed independently. Approving on net basis ignores this; the leverage cap is not the stated issue.

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