When pricing credit risk for an exposure, which of the following is a better measure than the others:

When pricing credit risk for an exposure, which of the following is a better measure than the others:
A . Expected Exposure (EE)
B . Notional amount
C . Potential Future Exposure (PFE)
D . Mark-to-market

View Answer

Answer: A

Explanation:

Exposure for derivative instruments can vary significantly over the lifetime of the instrument, depending upon how the market moves. The potential future exposure represents the extremes, not the most likely outcome. The expected exposure is the most suitable measure for pricing the credit risk. Over time, as multiple transactions are entered into, the expectation (or the mean) will be realized – though individual transactions may have more or less by way of exposure.

The notional amount may not be relevant, though for loans it may be the most important contributor to the expected exposure. Mark-to-market will represent the exposure at a given point in time, but cannot be predicted nor be used to price the credit risk.