PRM 3 – Question 103

[Jeffrey Chudy]

PRM 3 – Question 103

[Anonymous]

Hi,
The answer has a typo in it. The correct answer ‘c’ appears in both the “correct” and “incorrect” list.
Choice ‘c’ is the correct answer. Choice ‘a’, Choice ‘c’ and Choice ‘b’ are incorrect for these reasons.

Question 103 : A derivative contract has a negative current replacement value. Which of the following statements is true about its loan equivalent value for credit risk calculations over a 2-year horizon?
(a) Since the derivatives contract has a negative current replacement value, exposure will be zero.
(b) The current exposure can be used for loan equivalence calculations as that is an unbiased proxy for the future value.
(c) The credit exposure will be a given quintile of the expected distribution of the value of the derivatives contract in the future.
(d) The notional value of the derivatives contract should be used for loan equivalence calculations.

Your Answer is Correct

The correct answer is choice ‘c’

The current exposure is negative, so there is no immediate credit exposure. However, since the price of the derivative is volatile, we can reasonably expect the value to be greater than zero sometime in the future. This is a stochastic variable which will have a distribution, and not just a unique value, in the future that will represent the credit exposure. Since there is no unique value, a conservative approach is to pick a quintile of the distribution, and use that as the future value of the derivative contract, with the assurance that the probability of the credit exposure exceeding that quintile is known and has been consciously selected. This number can then be converted to a loan equivalent amount for credit risk purposes. Therefore Choice ‘c’ is the correct answer. Choice ‘a’, Choice ‘c’ and Choice ‘b’ are incorrect for these reasons.

[Anonymous]

Thank you once again. Well spotted, appreciate you taking the time to write and helping improve the content.

Now fixed.

Best regards,
Mukul

[Author]

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