Credit Risk Management Counterparty Credit Risk 1 — Questions and Answers
Question 1: Which measure represents the maximum potential exposure to a counterparty at a specified confidence level over a given time horizon?
- Potential Future Exposure (PFE) (Correct answer)
- Expected Exposure (EE)
- Credit Value Adjustment (CVA)
- Loan Equivalent Exposure (LEE)
Correct answer: Potential Future Exposure (PFE)
Potential Future Exposure (PFE) is the worst-case exposure at a specified confidence level (e.g., 95%) over a defined time horizon, used to set credit limits.
Question 2: Credit Value Adjustment (CVA) is best described as:
- The spread charged on a corporate bond above the risk-free rate
- The market value of counterparty credit risk embedded in a derivatives portfolio (Correct answer)
- The regulatory capital charge under Basel III for market risk
- The loss given default on a secured loan
Correct answer: The market value of counterparty credit risk embedded in a derivatives portfolio
CVA represents the difference between the risk-free portfolio value and the true portfolio value accounting for the possibility of counterparty default.
Question 3: Under a standard ISDA Master Agreement, netting reduces counterparty credit risk by:
- Requiring additional collateral posting when exposure exceeds a threshold
- Allowing positive and negative mark-to-market values across transactions to offset each other (Correct answer)
- Transferring credit risk to a central counterparty
- Capping the maximum exposure at the notional amount
Correct answer: Allowing positive and negative mark-to-market values across transactions to offset each other
Close-out netting under an ISDA agreement allows offsetting of gains and losses across all transactions with a counterparty upon default, reducing gross exposure to a net figure.
Question 4: Wrong-Way Risk (WWR) in counterparty credit risk refers to a situation where:
- A counterparty posts collateral of decreasing quality over time
- The exposure to a counterparty increases as the counterparty's creditworthiness deteriorates (Correct answer)
- Netting agreements are legally unenforceable in a bankruptcy jurisdiction
- Mark-to-market losses exceed posted initial margin
Correct answer: The exposure to a counterparty increases as the counterparty's creditworthiness deteriorates
Wrong-Way Risk occurs when exposure is adversely correlated with the credit quality of the counterparty — as the counterparty becomes more likely to default, the exposure grows.
Question 5: The Expected Positive Exposure (EPE) metric is primarily used for:
- Setting the credit limit for a single counterparty transaction
- Calculating regulatory capital for counterparty credit risk under Basel rules (Correct answer)
- Determining the credit spread on a newly issued bond
- Estimating the recovery rate on defaulted derivatives
Correct answer: Calculating regulatory capital for counterparty credit risk under Basel rules
EPE — the time-average of expected exposure over a horizon — is used in the IMM approach under Basel III to calculate regulatory capital requirements for CCR.
Question 6: Which of the following best describes a Credit Support Annex (CSA)?
- A legal document that specifies the terms for collateral exchange between OTC derivatives counterparties (Correct answer)
- A bond covenant that restricts the issuer's ability to take on additional debt
- A regulatory requirement for central clearing of standardized derivatives
- An amendment to a loan agreement that adds credit enhancement provisions
Correct answer: A legal document that specifies the terms for collateral exchange between OTC derivatives counterparties
A CSA is a schedule to the ISDA Master Agreement that governs collateral posting requirements, thresholds, minimum transfer amounts, and eligible collateral types.
Question 7: In the context of counterparty credit risk, the 'Threshold' in a CSA refers to:
- The minimum credit rating a counterparty must maintain to transact
- The unsecured exposure level below which no collateral is required (Correct answer)
- The maximum notional amount permitted under the master agreement
- The confidence level used to compute Potential Future Exposure
Correct answer: The unsecured exposure level below which no collateral is required
The threshold is the level of mark-to-market exposure up to which no collateral call is made; only exposure exceeding the threshold triggers a margin call.
Credit Risk Management Counterparty Credit Risk 1
Which measure represents the maximum potential exposure to a counterparty at a specified confidence level over a given time horizon?