Derivative notional is not the amount lost at counterparty default. Positive replacement value, enforceable netting and available collateral determine the exposed claim. An International Swaps and Derivatives Association (ISDA) Master Agreement and its Credit Support Annex (CSA) address different parts of that calculation.
An ordinary drawn loan mainly exposes the lender to unpaid principal and interest. Its current balance may be known, but future loan exposure can vary with amortization, revolver drawdowns and other contractual features. Many derivatives have bilateral, stochastic exposure: today's mark-to-market (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: Exposure at default (EAD) is not automatically loan face value or derivative notional. A derivative with no current claim can still have positive exposure in future market states. Revolver drawdowns can make lending exposure uncertain too.
Counterparty risk arises in over-the-counter (OTC) derivatives (swaps, forwards, options, structured), securities financing (repo, securities lending, prime brokerage margin), settlement (payment versus payment for foreign exchange (FX), or delivery versus...
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. Close-out netting requires an enforceable netting arrangement covering the trades. A CSA governs collateral and is not a prerequisite for netting. Check the contract, counterparties and relevant insolvency jurisdictions. 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. For an unconditional expected loss contribution, multiply exposure at default by default probability and loss given default (LGD), with discounting as appropriate.
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 at a future date), PFE or peak exposure (a chosen high percentile at that date), EPE (time-weighted EE), EEPE (time-weighted EEE), and maximum PFE across dates. 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 4,628 words, 31 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
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