Credit risk can be defined as the risk of suffering a loss as the result of accounts party failing to meet their obligations to you. One way that this can be quantified is using the formula on the screen. For the calculation of the expected loss, the loss that you think you might make in relation to accounts party, you need to take the probability of default, the chance that they fail to fulfill their obligations and you multiply this by the exposure at default which is the amount of money that they owe you in the event of default occurring. For a loan, this is gonna be straightforward. For OTC derivatives, it's a slightly more complicated calculation because the level of loss that counterparty is experiencing in the instance when they default is unknown at present. And then finally, we multiply this by the loss given default, which is the proportion of exposure you will lose if default occurs. Just because a counterparty owes you a million dollars when they default does not mean that you'll lose a million dollars for sure. If the counterparty has gone bankrupt, there will be some remaining assets in that bankrupt company so you are likely to get some of that money back. In addition, if you hold collateral, then the size of the gross exposure will be reduced by the size of the collateral previously pledged to you.

Holding collateral though does not reduce the risk down to zero for the dollar value of the exposure covered by the collateral because the value of the collateral is not fixed. If financial assets are held as collateral, there are many risks that are faced in relation to that. Firstly, market risk. If government bonds or corporate bonds or equity is held as collateral, there is a risk that those assets could decline in value between taking delivery of them as collateral and default on the counterparty. Credit risk alluded to the fact that the assets that are pledged to you could decline in value as a result of bankruptcy or reduction in credit worthiness of the issuer of those securities. Liquidity risk captures the idea that if a counterparty to an OTC derivative trade has gone bankrupt, there may be some market disruption. So, the ability that you have to sell financial assets for cash to meet obligations may be reduced. Finally, in holding collateral, there remains operational risk. There may be problems with systems or human errors might be made with regards to calculations of exposure, calling for collateral and legal enforceability of collateral arrangements. These risks can be mitigated through using haircuts. A haircut is where the value of collateral is reduced in terms of its ability to offset exposures. For example, if assets worth one million dollars were placed as collateral, but had a 10% haircut applied to them, they would only be worth $900,000 in terms of offsetting counterparty credit risk exposures. An alternative way of reducing the risks around collateral is to only permit certain types of collateral to be pledged. For example, cash as collateral doesn't face any market risk or credit risk or liquidity risk, significantly reducing the risks associated with that type of collateral.