Exposure of bonds purchased at discount

[george.bilkis]

Hi,

I am trying to evaluate credit risk of a bond portfolio and the first step is to calculate expected loss:
EL = Exposure * PD * LGD

I have a few questions:
A bank purchases a bond at a discount.
What is the exposure: is it the face value or the paid price?
Is it different for bonds purchased at the issue or purchased on the secondary market?

and another question:
In terms of common practice, does the exposure include the future interest on a loan or it is just an outstanding amount?
In coupon bonds, the paid price incorporates the future coupons.
A regular loan from a bank to a customer usually resembles the purchase of the bond at a discount.

Thanks,
G

 

[ShaktiRathore]

Exposure to the counter party is the net outstanding amount to the counter party.Outstanding amount is the amount which is to be received from the counter-party. Positive exposure to the counter-party has a credit risk while a negative exposure is no credit risk but there is forbearance of credit risk to the counter-party. Exposure is what is to be received from the counter-party which can change over time as value of the asset changes.
In bonds there is always a risk to the investor that the payments of coupons and Face value might not be paid. A distressed company might default on its bond and does not pay anything or something. So net exposure of company to investor is the total positive exposure that is PV of coupons and FaceValue which is to be received from the bond cash flows.
e.g. A writes put to B, the current share price is 40 and exercise price is 35. If after 3 days the share price goes to 30 than net exposure of B is 35-30=5 which is net amount which B is to receive from A(there can be default on part of A that is pay nothing at all on exercise of the option). After 5 days the share price is 20 than net exposure of B=35-20=15 which is net exposure which changed. even if B now does not exercise the put option and after 7 days the share price is 38 than net exposure of B is 0 , so now there is no exposure of B to A and hence no credit risk for B.

thanks

 

[george.bilkis]

Thanks.


I am not sure I understand your answer.
Just to avoid confusion, I am not asking about derivatives, only bonds and loans.
As to the bonds, when calculating PV (as you say) which interest rate do you use?

Does your answer mean that I should use as an exposure marked-to-market value of the loan and not the face value and not the paid price?
What about illiquid loan (say regular loan to a corporate customer)? The marked-to-market value is not observable. What then?

As to the derivatives, I don't think your answer is correct.
As far as I know, the potential exposure is used and not only the current replacement value of the contract.
Traders construct the future distribution and then use one of the following:
1. Expected exposure, which is roughly a value of European call option on the replacement value of the contract
2. Quantile exposure, say up to a 90% confidence - more conservative value

George