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Pinpoint the kinds of transactions that give rise to credit risk and characterise each.

FRM® Part II · Credit Risk Measurement and Management · Fundamentals of Credit Risk · FRM2.CR.1.c

The idea

Credit risk arises wherever a counterparty owes you value in future. Loans and bonds create exposure equal to the amount advanced or invested, which is known and one-way. Derivatives create exposure equal to the positive replacement value of the contract, max(MtM, 0). That exposure is uncertain, moves with the market and can switch from one party to the other. Netting and collateral reduce it. Credit lines, commitments, guarantees and letters of credit are contingent. Exposure at default is the drawn amount plus the share of the undrawn limit expected to be drawn by the time of default. Repos and securities lending are secured, so the exposure is the amount lent less collateral, adjusted for any fall in collateral value before it is sold. Settlement risk is the loss of principal when you pay and the counterparty does not deliver, as in cross-border FX. Match each product to how its exposure is measured.

Formulas

Exposure at default on a credit line

EAD = drawn + CCF × undrawn

drawn
the amount already drawn
CCF
the conversion factor, the share of the undrawn amount expected to be drawn by default
undrawn
the undrawn commitment

For commitments and other contingent exposures. Using only the drawn balance understates exposure, and using the full limit overstates it.

Current exposure on a derivative

exposure = max(MtM, 0)

MtM
the contract's market value to you, its replacement value

Without netting, apply it trade by trade and add: a negative trade cannot offset a positive one. With enforceable netting, apply it to the net value.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following is an off-balance-sheet source of credit risk for a bank?

  1. A committed but undrawn credit line granted to a corporate customer. - correct
  2. A drawn five-year term loan that has been advanced to a corporate customer.Why not: A drawn loan is an on-balance-sheet asset, so it is not an off-balance-sheet exposure.
  3. A holding of government bonds in the bank's banking book, bought for investment.Why not: Bonds held are on-balance-sheet assets and are not contingent commitments.
  4. A deposit placed with another bank in the wholesale interbank market.Why not: An interbank deposit placed is an on-balance-sheet asset, not a contingent or undrawn commitment.

Commitments, guarantees and letters of credit create contingent exposure that may become an asset if drawn. Loans, bonds and placements are already on the balance sheet.

A harder one

A bank has two OTC derivatives with the same counterparty, with market values to the bank of +USD 8 million on trade 1 and -USD 5 million on trade 2. There is no netting agreement and no collateral. If the counterparty defaults today, the bank's current credit exposure is:

  1. USD 3 millionWhy not: Nets the two trades (8 - 5), which is only valid with an enforceable netting agreement; the stem says there is none.
  2. USD 8 million - correct
  3. USD 13 millionWhy not: Adds the absolute values (8 + 5), treating the trade the bank owes on as if it were also an exposure.
  4. USD 5 millionWhy not: Uses only the negative trade; the exposure comes from the trade with positive value to the bank.

Without netting, exposure is the sum of positive values only: max(8,0) + max(-5,0) = 8 million. The bank must still pay on trade 2 to the estate, so it cannot offset it.

The hardest tier

A bank grants a USD 50 million revolving credit line, of which USD 20 million is drawn. Internal analysis shows that, in the year before default, borrowers typically draw 60 percent of the undrawn amount. The bank's exposure at default on this line is closest to:

  1. USD 20 millionWhy not: Counts only the amount drawn today and ignores the further drawdown expected before default.
  2. USD 50 millionWhy not: Assumes the full limit is drawn at default, whereas analysis indicates only 60 percent of the undrawn amount is drawn.
  3. USD 38 million - correct
  4. USD 18 millionWhy not: Counts only the expected additional drawdown (0.6 x 30) and omits the 20 million already drawn.

EAD = drawn + CCF x undrawn = 20 + 0.60 x (50 - 20) = 20 + 18 = 38 million. Commitments create contingent exposure that includes expected usage before default.

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