credit risk practice qn

[narayananvenkat]

David..

Look at this qn:


If Frim X owes $3 million to Firm Y in one contract but Frim Y owes $ 4 million to Firm X in another contract, net credit exposure to Firm y is

1. -$1 million
2.$0
3.+1million
4.+7million

The stem looks tricky. is'nt it?

venkat

 

[David Harper CFA FRM]

venkat:

To Firm Y, the $3 MM owed by Firm X has +3 value; i.e., Y is "in the money" on this contract, if X defaulted, that's the cost to replace the contract.
To Firm Y, the $4 MM it owed Firm X has -$4 value; i.e., the oppositive of exposure
... and the current exposure of this 4 is MAX(-4, 0) = 0; i.e., Firm Y owes and it therefore not exposed to credit risk

If they net, Firm Y has net exposure +3 - 4 = -1
and Firm X has +4 (exposure if Y defaults) - 3 = +1

without netting, Firm Y's exposure is +3

David

 

[narayananvenkat]

David..

thanks for a simple and eloborate reply. i also felt the net cr exp to be -1.

But Schweser says answer is Zero since negative values are not recognised while expressing net credit exposure.

venkat

 

[David Harper CFA FRM]

... oh, right, i should have

* current *value* = -1, such that
* exposure is indeed = max(-1,0)

...fooled me ... i got sloppy at the end. It's a good lesson in paying careful attention to the question asked.

David