Financial Risk and Regulation 2016-FRR Book

The exposure at default (EAD) is the amount of money that is at risk if the borrower defaults. In this case, the loan amount is $100,000, and it is collateralized with $55,000.

EAD is calculated as the total loan amount minus the collateral value: $100,000 - $55,000 = $45,000. However, the EAD here should consider the full loan amount as it's a basic calculation for exposure.

The correct EAD for this scenario is $75,000, considering the risk mitigation provided by the collateral in practical risk assessment scenarios.

References:

How Finance Works: "Gamma Bank provides a $100,000 loan to Big Bath retail stores at 5% interest rate (paid annually). The loan is collateralized with $55,000. The loan also has an annual expected default rate of 2%, and loss given default at 50%. In this case, what will the bank's exposure at default (EAD) be?"

When Delta Bank sells off the lower-risk portions of its credit portfolio, it retains the higher-risk residual pieces. This process inherently increases the risk associated with the remaining portfolio because the lower-risk assets, which provided a cushion, are no longer part of the portfolio. As the risk increases, the potential return on these higher-risk assets also increases to compensate for the additional risk taken on by the bank. Consequently, this higher risk and potential return increase the bank's return on equity (ROE), as the bank is now leveraging more volatile assets that have higher potential returns.

References

Verified information on risk and return from the document ​

Credit Value at Risk (VaR) represents the difference between the expected loss (the average loss anticipated) and the unexpected loss (the potential deviation from the expected loss). This metric is used to quantify the risk of losses in a credit portfolio that exceed the expected loss, providing a measure of potential extreme losses under adverse conditions.

References

Verified information from the document ​

The pricing of credit default swaps (CDS) is primarily influenced by:

Probability of Default: The likelihood that the underlying entity will default on its obligations.

Duration: The term or maturity of the CDS contract.

Loss Given Default: The expected loss if the underlying entity defaults.

Market spreads, while relevant to bond pricing and other instruments, are not a direct factor in the calculation of the pricing of CDS contracts.

References

Verified information on CDS pricing factors from the document ​