Credit Risk Management Practice Exam

What happens to exposures if netting is not applied during transactions?

1. Exposures remain the same

2. Exposures are minimized

3. Exposures are additive

4. Exposures are eliminated

The correct answer is: Exposures are additive

When netting is not applied during transactions, exposures become additive. This means that rather than offsetting the amounts owed between parties, each transaction is treated separately, resulting in a higher cumulative exposure. In financial transactions, netting allows for the aggregation of receivables and payables, so only the net obligation needs to be settled. Without netting, if one party owes money from multiple transactions while simultaneously being owed money in separate transactions, the total exposure is simply the sum of all the individual amounts rather than a single net amount. This leads to an increase in the overall credit risk because the parties may face larger amounts if obligations are not being offset against each other. The additive nature of exposures without netting is critical in understanding how credit risk increases with separate transactions since it exposes the parties to the total amount owed rather than a reduced obligation.