Which one of the following deals would have the greatest credit exposure for a $1,000,000 deal size (assume the counterparty in each deal is an AAA-rated bank and has no settlement risk)?
A. Pay fixed in an Australian dollar (AUD) interest rate swap for one year.
B. Sell USD against AUD in a one-year forward foreign exchange contract.
C. Sell a one-year AUD cap.
D. Purchase a one-year certificate of deposit.
Answer:D
The CD has the whole notional at risk. Otherwise, the next greatest exposure is for the forward currency contract and the interest rate swap. The short cap position has no exposure if the premium has been collected. Note that the question eliminates settlement risk for the forward contract.