In general EAD can be seen as an estimation of the extent to which a bank may be exposed to a counterparty in the event of, and at the time of, that counterparty’s default.
A total value that a bank is exposed to at the time of default. Each underlying exposure that a bank has is given an EAD value and is identified within the bank’s internal system.
EAD – along with loss given default (LGD) and probability of default (PD) – is used to calculate the credit risk capital of financial institutions.
The probability of default (also call Expected default frequency) is the likelihood that a loan will not be repaid and will fall into default. PD is calculated for each client who has a loan (for wholesale banking) or for a portfolio of clients with similar attributes (for retail banking). The credit history of the counterparty / portfolio and nature of the investment are taken into account to calculate the PD.
The amount of funds that is lost by a bank or other financial institution when a borrower defaults on a loan.
Institutions such as banks will determine their credit losses through an analysis of the actual loan defaults. While quantifying some losses may be simple, in some situations it may be quite difficult and require the analysis of multiple variables. For example, if Bank X loans $1 million to ABC Company and ABC defaults on the note, Bank X’s loss isn’t necessarily $1 million. This is because Bank X may hold substantial assets as collateral, and/or may use the courts in an effort to be made whole. When all of these variables are factored in, Bank X may have lost substantially less than the original $1 million loan. The process of analyzing all of these variables (as well as all of the other loans in Bank X’s portfolio) is paramount to determining the loss given default.
The accounting act of recording the price or value of a security, portfolio or account to reflect its current market value rather than its book value.
Problems can arise when the market-based measurement does not accurately reflect the underlying asset’s true value. This can occur when a company is forced to calculate the selling price of these assets or liabilities during unfavorable or volatile times, such as a financial crisis. For example, if the liquidity is low or investors are fearful, the current selling price of a bank’s assets could be much lower than the actual value. The result would be a lowered shareholders’ equity.
This issue was seen during the financial crisis of 2008/09 where many securities held on banks’ balance sheets could not be valued efficiently as the markets had disappeared from them. In April of 2009, however, the Financial Accounting Standards Board (FASB) voted on and approved new guidelines that would allow for the valuation to be based on a price that would be received in an orderly market rather than a forced liquidation, starting in the first quarter of 2009.
A netting agreement between two parties, say A and B means that on payment default by the counterparty A, B can legally offset that default by the same amount which it owes to A. Without a netting agreement B still has to pay what it owes to A even if A has defaulted payment on other trades.
So if you say that a trade is NETTED, that means it is covered by the netting agreement.
One of the major reasons for netting is that it adds additional security in the event of a bankruptcy to either party. By netting, in the event of bankruptcy, all of the swaps are executed instead of only the profitable ones for the company going through the bankruptcy. For example, if there was no bilateral netting, the company going into bankruptcy could collect on all in the money swaps while saying they can’t make payment on the out of the money swaps due to the bankruptcy.
Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
In general, the reason for which a stock is traded over-the-counter is usually because the company is small, making it unable to meet exchange listing requirements. Also known as “unlisted stock”, these securities are traded by broker-dealers who negotiate directly with one another over computer networks and by phone.
Counterparty is the other party that participates in a financial transaction. Every transaction must have a counterparty in order for the transaction to go through.
Within the financial services sector, the term market counterparty is used to refer to governments, national banks, national monetary authorities and international monetary organisations such as the World Bank Group that act as the ultimate guarantor for loans and indemnities.