Outline the parameters that most often define a credit-sensitive transaction.
The idea
A credit-sensitive transaction is defined by a small set of parameters that together fix the risk the lender takes. The main ones are the obligor and its credit quality, the amount (the commitment and how much is drawn), the tenor or maturity, the type of facility and its purpose, and the repayment profile (bullet or amortising). The rest are pricing in the form of margin and fees, collateral and guarantees, the seniority or ranking of the claim, and covenants and other terms such as currency. Amount, tenor and repayment profile drive exposure over time. Collateral, guarantees and seniority mainly affect the loss if default occurs, not its probability. Covenants give early warning and a right to intervene. Candidates often attribute collateral to default probability instead of loss given default.
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
The commitment, the drawn amount and the expected drawdown all enter. The trap is applying the CCF to the whole commitment instead of the undrawn part.
A practice question
Which pair of transaction parameters most directly determines the size and duration of a bank's credit exposure?
- Pricing (margin) and fees.Why not: Pricing compensates for risk but does not set how much or for how long the bank is exposed.
- Collateral and guarantees.Why not: These are risk mitigants affecting the loss on default, not the size or duration of exposure.
- Covenants and the stated purpose of the loan.Why not: These shape monitoring and use of funds, not the amount outstanding or its term.
- Amount (commitment) and tenor (maturity). - correct
Exposure is the amount lent for the period of the tenor; the other parameters price it or reduce loss.
A harder one
What is the purpose of financial covenants in a loan agreement?
- To fix the schedule on which principal is repaid.Why not: This is the repayment profile, not a covenant.
- To compensate the lender for the credit risk through the interest margin it charges.Why not: This is pricing, not a covenant.
- To give the lender early warning and a right to act if the borrower weakens. - correct
- To rank the lender's claim relative to other creditors in bankruptcy.Why not: This is seniority, not a covenant.
Covenants such as leverage or coverage tests are contractual triggers that let the lender renegotiate or intervene before losses occur.
The hardest tier
A revolving credit facility has a commitment of USD 50 million, of which USD 20 million is drawn. The bank estimates that 60 percent of the undrawn amount will be drawn by the time of default. What exposure at default should it use?
- USD 20 million.Why not: Counts only the drawn amount and ignores the expected draw on the undrawn commitment.
- USD 38 million. - correct
- USD 50 million.Why not: Assumes the full commitment will be drawn, ignoring the 60 percent conversion estimate.
- USD 18 million.Why not: Applies the 60 percent only to the undrawn amount and then forgets to add the USD 20 million already drawn.
Undrawn = 50 - 20 = 30. EAD = 20 + 0.6 x 30 = 38. The commitment, the drawn amount and the expected draw down all enter the exposure.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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