Credit Risk Management Practice Exam

What is enhanced by collateralization in terms of exposure management?

1. Credit exposure only

2. Counterparty risk and funding costs

3. Regulatory compliance

4. Trading volume

The correct answer is: Counterparty risk and funding costs

Collateralization plays a critical role in exposure management, particularly in reducing counterparty risk and funding costs. When a party provides collateral, it serves as a security against the risk that the counterparty may default on their obligations. This arrangement enhances the creditworthiness of the transaction, as the collateral can be liquidated to cover any losses incurred due to default. As a result, the risk of financial loss is significantly mitigated. Moreover, by reducing counterparty risk, institutions may also experience lower funding costs. Lenders and investors often view transactions with collateral as less risky, which can lead to more favorable borrowing terms and lower interest rates. This aspect supports a more efficient allocation of capital. In contrast, while credit exposure is certainly impacted by collateralization, the primary enhancement resulting from this practice is the reduction in both counterparty risk and associated funding costs. Regulatory compliance, while important, is a separate concern and is not directly enhanced by the act of collateralization itself. Trading volume can be influenced by various factors but does not have a direct correlation with the benefits provided through collateralizing exposures. Thus, the most comprehensive outcome linked to collateralization involves the enhancement of counterparty risk management and the consequent reduction in funding costs.