Why is there an add-on amount in Basel I for derivatives transactions?
“Basel I could be improved if the add-on amount for a derivatives transaction depended on the value of the transaction.” How would you argue this viewpoint?
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I'm not aware of the exact directives in the Basel I norms with regards to what the add-on amount for derivatives is. But your statement that "Basel I could be improved if the add-on amount for a derivatives transaction depended on the value of the transaction," is not right.
The additional risk that could be acquired by banks during transactions of derivatives is many times the value of the transaction. As an example to illustrate this point, let's take the case of call options. The party issuing the option takes upon itself all the risk for the price of the asset rising. If the option's strike price is $50 and the asset’s price goes up to $100, there is a loss of $50 for the seller. The transaction amount would not equal the loss that the seller could be forced to bear but is instead a small fraction of that.
It is therefore not sufficient for an add-on capital requirement to be decided by the transaction cost. Capital requirements for banks are fixed keeping in mind the risk that they are taking on. This protects the bank from going bankrupt in case any unanticipated event actually occurs.
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