Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

8.3 Factors Driving Credit Exposure

We now give some examples of the significant factors that drive exposure, illustrating some important effects such as maturity, payment frequencies, option exercise, roll-off and default. Our aim here is to describe some key features that must be captured, whilst the next chapter will give actual examples from real trades. In all the examples below, we will depict PFE defined as a percentage of the notional of the transaction in question.

8.3.1 Loans and Bonds

The exposures of debt instruments such as loans and bonds can usually be considered almost deterministic and approximately equal to the notional value. Bonds typically pay a fixed rate and therefore will have some additional uncertainty since, if interest rates decline, the exposure may increase and vice versa. In the case of loans, they are typically floating-rate instruments but the exposure may decline over time due to the possibility of prepayments.

8.3.2 Future Uncertainty

The first and most obvious driving factor in exposure is future uncertainty. Forward contracts such as forward rate agreements (FRAs) and FX forwards are usually characterised by having just the exchange of two cash flows or underlyings (often netted into a single payment) at a single date, which is the maturity of the contract. This means that the exposure is a rather simple increasing function reflecting the fact that, as time passes, there is increasing uncertainty about the value of the final exchange. Based ...