Lehman's swaps book in September 2008 had hundreds of billions of gross notional and a few billion of net replacement value. The gross number is meaningless for credit risk; the net number is meaningful only if netting holds in default. ISDA enforceability across jurisdictions, ranking of close-out claims, and CSA collateral terms decide whether your "net" exposure is the actual loss when your counterparty fails. Counterparty credit risk is one part exposure measurement and three parts legal documentation.
A loan has unidirectional, deterministic exposure: the bank lent $50M and is owed $50M plus accrued interest, with default loss bounded by face value. A derivative has bilateral, stochastic exposure: today's MTM can be zero, positive, or negative, and only the in-the-money side has credit exposure at default. Exposure is path-dependent: a swap slightly in your favor today can be deeply in your favor in three years.
KEY: Lending risk has deterministic exposure at default (EAD). Counterparty risk has stochastic EAD that can be zero today and large tomorrow. Simulation-based exposure measurement is required.
Common mistakes
- Treating gross notional as exposure. Gross notional is the trade size, not the credit risk. A $100M IRS has $100M notional but only a few percent of that as PFE. Exposure equals positive MTM, not notional. Trap: a question gives notional and asks for current exposure; the answer requires the MTM, not the notional.
- Assuming netting is automatic. Netting requires an ISDA master agreement, signed CSA terms, and legal enforceability in the counterparty's jurisdiction. Without all three, gross exposure applies. Trap: a question describes trades with a foreign counterparty and asks about netting benefit; the answer must check jurisdiction enforceability.
- Confusing EE and PFE. Expected Exposure is the mean; Potential Future Exposure is a high percentile (typically 95%). EE drives CVA pricing; PFE drives credit limits. Trap: a question asks for "expected loss given counterparty default in two years" and the answer requires EE × PD × loss given default (LGD); using PFE overstates expected...
Bottom line
- Counterparty risk differs from lending risk: exposure is bilateral (either side can owe) and stochastic (depends on future market moves). EAD is not face value; it is the in-the-money replacement value at default.
- Exposure metrics: CE (today), EE (mean future), PFE (95th percentile), EPE (time-weighted EE), EEPE (time-weighted EEE), and Maximum Exposure. Each answers a different question.
- The ISDA Master Agreement is the standard single-agreement framework for OTC derivatives (close-out netting, default and termination events); the Credit Support Annex (CSA) governs collateralization within it.
- Netting reduces gross exposure to net replacement cost, but only if legally enforceable in the counterparty's jurisdiction at default; otherwise gross exposure applies.
Exam shortcut
When a question gives you net MTM, threshold, existing collateral, MTA, and rounding, plug them into the credit support formula in order. When it asks "what is exposure" without specifying which metric, default to PFE for limits questions and EE for pricing questions. When it describes wrong-way risk explicitly, assume the standard CVA model understates risk and the right answer requires a WWR adjustment.
The full lesson (about 2,825 words, 19 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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