P2.T6.318 Counterparty risk terms, continued

Nicole Seaman

Director of CFA & FRM Operations
Staff member
Subscriber
AIM: Define the following terminology related to counterparty risk: ... replacement cost, asymmetric exposure, and potential future exposure.

Questions:

318.1. A bank has a position in an over the counter (OTC) derivatives contract with a counterparty. The current mark-to-market (MtM) value of the bank's position is +$4.0 million, but the position is highly illiquid. There is no collateral or margin involved and the net counterparty risk happens to be zero: that is, the net CVA adjustment is zero. If the counterparty defaults, the bank expects a recovery rate of 35%. Which of the following most is the best estimate of the bank's position's replacement cost?

a. Replacement cost is about $1.4 million
b. Replacement cost is about $2.6 million
c. Replacement cost is less than $4.0 million
d. Replacement cost is more than $4.0 million


318.2. Credit exposure is asymmetric and, according to Gregory, can be likened to an option position. Which of the following best describes this?

a. Credit exposure = min(MtM,0) --> long option position
b. Credit exposure = min(-MtM,0) --> long option position
c. Credit exposure = max(MtM,0) --> short option position
d. Credit exposure = max(-MtM,0) --> long protective put

(Source: Jon Gregory, Counterparty Credit Risk: The New Challenge for Global Financial Markets (West Sussex, UK: John Wiley & Sons, 2010))

318.3. Each of the following is true about the term Potential Future Exposure (PFE) EXCEPT which is false?

a. PFE varies with confidence level, like value at risk (VaR)
b. PFE will approximately equal the notional at contract inception
c. PFE is an estimate of credit exposure on a future date
d. PFE must be at least zero

Answers:
 
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