Credit Risk Management Practice Exam

What is credit exposure in the context of counterparty risk?

1. The maximum potential loss from a counterparty default

2. The amount owed to a financial institution by a single borrower

3. The amount of collateral held against a loan

4. The interest rate charged on a credit transaction

The correct answer is: The maximum potential loss from a counterparty default

Credit exposure in the context of counterparty risk refers specifically to the maximum potential loss that could occur if a counterparty defaults on their obligation. This concept is crucial for financial institutions as it helps them assess the risk they face from counterparties in various transactions, particularly in derivatives and trading activities. When evaluating credit exposure, institutions must consider the potential future credit exposure, which varies depending on market conditions and the creditworthiness of the counterparty. This includes not only the current amount owed but also the potential change in value of outstanding derivatives leading to further losses. Hence, understanding credit exposure allows risk managers to establish adequate capital reserves to cover potential defaults, thus ensuring financial stability and compliance with regulatory requirements. The other choices focus on different aspects of credit risk management. The amount owed to a financial institution describes the outstanding debt but does not encompass the potential risk associated with counterparties failing to meet their obligations. The amount of collateral held speaks to risk mitigation strategies but does not define exposure itself. The interest rate reflects the cost of borrowing and the reward for lending but does not address the specific risk of counterparty default. Therefore, the first choice accurately captures the essence of credit exposure in this context.