NET EXPOSURE
In the gross credit exposure, we assume that neither credit enhancements (CE) nor recoveries are applied against the above mentioned events; in other words, it is an uncollateralized exposure.
However, the riskiness of gross exposure against default or downgrading events can be covered by employing credit enhancements, which make up the collateralized net exposure. Thus, quantifying the amount of credit enhancements attached to gross exposure at any PIT t is essential. The general equation for estimating the current net exposure at time t of a default event, also called exposure at default (EAD), is defined1 in 9.1Enet (t) = Egmss (t) - CE (t) (9.1)
As discussed in Chapter 10 there are market and counterparty driven credit enhancements that may be applied at possible future time of credit event, i.e., default or downgrading. There are rules that must be applied when credit enhancements are employed, to mention a few: the guarantors must have higher credit quality rating than the obligor; also the financial collaterals may fluctuate based on market conditions and thus haircut analysis is applied; moreover, wrong way risk must be measured. Finally, a possible maturity mismatch,2 between the exposure and the credit enhancements must also be considered. Any change of the value and employment process of credit enhancements will have an impact in net exposure and thus must be clearly identified, measured and monitored.
9.3