Test Exam 3 Question 94

[Anonymous]

Question 94 : Company A issues bonds with a face value of $100m, sold at issuance at $98. Bank B holds $10m in face of these bonds acquired at a price of $70. What is Bank B’s exposure to the debt issued by Company A?

(a) $10m

(b) $7m

(c) $6.86m

(d) $9.8m

Your Answer is Incorrect

The correct answer is choice ‘b’

Bank B’s exposure is measured by the price it paid for the bonds, which in this case is $7m ($10m x 70/100). Hence Choice ‘b’ represents the correct answer.

(Note that the question is asking for ‘exposure’ and not the legal claim in the event of default. The legal claim in the event of default would be the full notional of $10m. )

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In PRM Handbook III.B.2.3, Exposure (At Default) is defined as “the total amount of the payment obligations of obligor” which in that case is the face amount of $10m.
In PRM Handbook III.B.3.3, bond exposure figure shows the exposure profile for such a bond.
I don’t understand why the price paid should be relevant, this does not seem consistent (except maybe from a pure accounting point of view)

[kzg]

Test Exam 3 Question 94

[Anonymous]

I think that the bond example in the Handbook is predicated on the bond currently trading at par. But in the Question above the bond is trading at a price of $70, well below par. What this means is that even though we’ve got a lot of coupons and a redemption amount of $10 million we will miss out on if the issuer defaults, the fact is that these future cashflows are only worth $7m in today’s terms given prevailing interest rates. In other words, if you Net Present Value these future cash inflows they are only worth $7m. So in that sense your exposure is only $7m.

[Anonymous]

Jim,
We don’t know how much the bond currently quotes.
We only know that bank B acquired it at a price of $70 (it could have been years ago), and I don’t see why Bank B’s exposure should be measured “by the price it paid for the bonds”.
If so, let’s say that bank B bought the bond for a symbolic $1 (following bankrupcy of a counterparty, for example) : does that mean that its exposure is $1 ? I don’t think so.

[Author]

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