QUESTION 1: You have been provided with the formula for expected credit loss. ABC has a...

QUESTION 1: You have been provided with the formula for expected credit loss.

ABC has a $30 million Accounts Receivable due in one year from Omega Corp, a BBB rated entity. ABC Corp purchases a credit default swap (CDS) from XYZ Insurance (a AA entity) against the risk of default by Omega Corp. Answer the following:

Describe the credit exposure, if any, that ABC has in this transaction and if it has been completely eliminated by the purchase of the CDS.

Assume ABC has received $10 million cash collateral, that the probability of default is 0.30% and the recovery rate is 0.40 (40%), what is the expected loss to ABC. Show the formula and details of your calculation.

Expert Solution

1st part In this case, ABC Corp has purchased a credit default swap (CDS) from XYZ Insurance (a AA entity) against the risk of default by Omega Corp of outstanding receivables of $30 million. Thus, the credit exposure of ABC is eliminated in this case, however he will be paying the high premium amount for the purchase of CDS from XYZ Insurance as Omega Corp is a BBB rated entity.

2nd part

Receivable by ABC - $30 million

Collateral received (cash) - $ 10 million

Net exposure = Exposure at default (EAD)= $30 million - $10 million = $ 20 million

Probability of default (PD) = 0.30%

Recovery rate = 40%

Loss given default (LGD) = 100%- recovery rate (40%) = 60%

Expected loss = Exposure at default (EAD) * Probability of default (PD) * Loss given default (LGD)

= 20 * 0.30 * 0.60

= $ 3.6 million

Thus, expected loss to ABC is $ 3.6 million.

ekkarill92 answered 2 years ago

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