Wrong-way exposure

Unlike loans, swaps and other forward trades have uncertaincredit exposure that depends on the movementof market rates. To place these deals on a comparablebasis to loans, we need to determine the expectedexposure to the counterparty for each futureperiod.1 The expected exposure for a deal at a givenfuture point is the expected value of MAX(deal value, 0). Market practiceis to calculate this under the standard distribution assumed when valuingoptions on underlying rates. Under this distribution, the expected value ofthe deal is its forward value. This distribution assumption is valid only aslong as the solvency of the counterparty has no relation to the deal’s underlyingmarket rates.

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