Credit exposure for derivatives is measured using

Credit exposure for derivatives is measured using
A . Current replacement value
B . Notional value of the derivative
C . Forward looking exposure profile of the derivative
D . Standard normal distribution

View Answer

Answer: C

Explanation:

Current replacement values are a very poor measure of the credit exposure from a derivative contract, because the future value of these instruments is unpredictable, ie is stochastic, and the range of values it can take increases the further ahead in the future we look. Therefore it is common for credit exposures for derivatives to be measured using forward looking exposure profiles, which are distributions of the expected value of the derivative at the time horizon for which credit risk is being measured. To be conservative, a high enough quintile of this distribution is taken as the ‘loan equivalent value’ of the derivative as the exposure. Choice ‘c’ is the correct answer.

The notional value of derivative contracts generally tends to be quite high and unrelated to their economic value or the counterparty exposure. Therefore notional value is irrelevant.