In the context of Basel 2 requirements (BCBS128), how hedges affect the computation of counterparty exposure used in RWA calculation? Specifically, do hedges reduce the amount of exposure (EAD)?
Example: RWA OTC exposure of EAD 100 with a hedge of 2. Is the amount used for RWA computation 98 or 100?
References would be nice to have.
So, basically, the answer is no.
For capital requirements Basel has three categories:
a) Counterparty Credit Risk
b) Market Risk
c) Operation Risk
All RWA calculations are additive.
If your hedge is with the same counterparty then it likely offsets a) and b) and possibly c). If your hedge is only a market hedge then it will only offset b) and possibly some c). Counterparty credit risk (which in my experience can be the dominant factor) is only offset if the trades are with the same counterparty as part of a portfolio netting set.
The Basel Framework: https://www.bis.org/basel_framework/index.htm?m=3%7C14%7C697 does a good job of breaking up sections into readable chunks.
There are two calculations of RWA:
a) a standardised approach - the calculation rules are spelled out by Basel
b) an internal model based - a bank sets the rules (approved by basel) and cannot be more conservative than those of a fraction of a).
I would suggest you learn a). Therefore you will want to read at least CR20-22, for counterparty credit risk component.
Depending upon what typr of product you have there are many different instructions for example, I care about Interest Rate Swaps, which are typically collateralised OTC derivatives, and in CRE22.81 it tells me to calculate exposure in the method from CRE52, which itself provides a good deal of example calculations.
