Chapter 22

Credit Exposure

Credit exposure is the amount at risk during the life of the financial instrument. Upon default, it is called exposure at default (EAD). When banking simply consisted of making loans, exposure was essentially the face value of the loan. In this case, the exposure is the notional amount and is fixed.

Since the development of the swap markets, the measurement of credit exposure has become more complicated. This is because swaps, like most derivatives, have an up-front value that is much smaller than the notional amount. Indeed, the initial value of a swap is typically zero, which means that at the outset, there is no credit risk because there is nothing to lose.

As the swap contract matures, however, it can turn into a positive or negative value. The asymmetry of bankruptcy treatment is such that a credit loss can occur only if the instrument has positive value, or is a claim against the defaulted counterparty. Thus, the credit exposure is the value of the asset if it is positive, like an option.

This chapter turns to the quantitative measurement of credit exposure. Section 22.1 describes the general features of credit exposure for various types of financial instruments, including loans or bonds, guarantees, credit commitments, repos, and derivatives. Section 22.2 shows how to compute the distribution of credit exposure and gives detailed examples of exposures of interest rate and currency swaps. Section 22.3 discusses exposure modifiers, or techniques ...

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