Credit Risk Management Practice Exam

What is the typical Potential Future Exposure (PFE) profile for bonds, loans, and repos?

1. It varies significantly over time

2. Roughly equal to 50% of the notional value

3. Roughly equal to 100% or notional value

4. It is always zero

The correct answer is: Roughly equal to 100% or notional value

The Potential Future Exposure (PFE) profile for bonds, loans, and repos is generally considered to be roughly equal to 100% of the notional value due to the nature of these financial instruments and the credit risks associated with them. PFE measures the maximum expected credit exposure over a specified time period at a certain confidence level. For bonds and loans, which typically involve a principal amount that the issuer must repay at maturity, the potential future exposure can logically be viewed as equal to the notional amount, especially as the repayment date approaches. Repos, being short-term secured loans, also carry significant risk based on the collateral and the underlying amount, and as such, it reflects similar exposure. This expected exposure must accommodate for the potential fluctuations in value over the term of the investment and the likelihood of counterparty default, thus cementing the typical assessment of exposure to be at or near the notional value. In contrast, variations over time, or a lower exposure percentage like 50%, may apply to different financial instruments or less conventional arrangements where underlying risks are significantly lower or more variable, but such scenarios do not align with the traditional understanding of PFE for bonds, loans, and repos. Moreover, a PFE of always zero is