Modelling the impact of close-out netting on bank portfolios

The stochastic volatility of daily foreign exchange (FX) derivatives poses a number of risks for the international banking community. Settlement risk, liquidity risk and capital adequacy are just a few immediate concerns that arise from such volatility. This thesis examines the impact of close-out netting on minimising the stochastic volatility of inter-bank FX derivatives. The problem with close-out netting is that although it is a simple formula of taking the differences between two banks at one point in time, it is the stochastic and volatile nature of FX rates that makes measuring the full impact of netting difficult.

The objective of this thesis is to establish a realistic international banking framework or modelling environment in which close-out netting can be scientifically applied and examined. Five international daily FX rates will be used as sufficient approximations for five international banks. A generalised autoregressive conditionally heteroschedastic (GARCH) modelling approach is adopted as a robust and rich FX volatility paradigm. Then through Monte Carlo simulation of the resulting fitted GARCH models, we generate the distributions -with and without close-out netting.

The findings of this thesis are interesting, showing that close-out netting is far more than just a simple mathematical process. Netting surely does reduce each bank's exposure to FX volatility, however, its multivariate nature reveals some important results for banking risk research and bank analysts.