Credit Risk Management Practice Exam

Which concept compares the present value of potential gains and losses from counterparty exposure?

1. Mark-to-market (MtM)

2. Loan-to-value ratio

3. Net asset value

4. Equity capitalization

The correct answer is: Mark-to-market (MtM)

The concept that compares the present value of potential gains and losses from counterparty exposure is known as Mark-to-market (MtM). This approach involves evaluating the current market value of securities or derivatives to understand the potential risks and rewards associated with a counterparty's credit exposure. Mark-to-market accounting facilitates the continuous assessment of the financial positions of counterparties, allowing for more dynamic risk management. By calculating the present value of potential future cash flows, risk managers can identify how changes in market conditions or counterparty credit quality might impact the profitability or risk exposure of existing contracts. This is crucial for firms engaged in trading or with significant counterparty relationships, as it supports informed decision-making around risk mitigation strategies. Other choices like the loan-to-value ratio, net asset value, and equity capitalization focus on metrics related to lending and asset valuation, but they do not specifically address the current market conditions relating to counterparty risk exposure in the context of potential gains and losses. Thus, they do not capture the essence of assessing counterparty risk as effectively as the Mark-to-market approach does.