3.2 Components and Terminology

3.2.1 Credit Exposure

Credit exposure (hereafter often simply known as exposure) defines the loss in the event of a counterparty defaulting. Exposure is characterised by the fact that a positive value of a financial instrument corresponds to a claim on a defaulted counterparty, whereas in the event of negative value, an institution is still obliged to honour their contractual payments (at least to the extent that they exceed those of the defaulted counterparty). This means that if an institution is owed money and their counterparty defaults then they will incur a loss, whilst in the reverse situation they cannot gain9 from the default by being somehow released from their liability.

Exposure is clearly a very time-sensitive measure since a counterparty can default at any time in the future and one must consider the impact of such an event many years from now. Exposure is needed in the analysis of counterparty risk since, for many financial instruments (notably derivatives), the creditor is not at risk for the full principal amount of the trade but only the replacement cost. A measure of exposure should encompass the risk arising from actual claims (current claims and those a financial institution is committed to provide), potential claims (possible future claims) as well as contingent liabilities. Essentially, characterising exposure involves answering the following two questions:

  • What is the current exposure (the maximum loss if the counterparty ...

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