Exposure at default measures the amount at risk when a borrower or counterparty defaults. A revolving-credit ledger separates current drawings, commitment, EAD and recovery.
Exposure at default
Exposure at default (EAD) is the amount exposed to a borrower or counterparty when default occurs, measured under a specified exposure convention. Before default, EAD is usually an estimate of that amount. A credit limit, today's loan balance and a model's EAD can therefore be three different numbers: a borrower may draw more money before failing.
EAD answers how much is exposed. Probability of default answers how likely default is; loss given default answers what fraction of the exposure is lost after recovery. EAD is a money amount, not a probability or a loss percentage.
From today's balance to a default estimate
Consider a fictional revolving facility. All amounts are USD millions. Today the borrower has drawn 60 against a limit of 100, leaving 40 undrawn. For this example, assume no repayments, interest accrual, fees or limit changes before default. Stipulate that 50% of today's undrawn amount will become an additional outstanding balance if default occurs over the chosen horizon.
A simple conversion model is
EAD=D+c(L−D),
where D is the current drawn balance, L is the facility limit and c is the assumed conversion fraction of the undrawn commitment. Here,
EAD=60+0.50(100−60)=80USD million.
Quantity
USD million
Meaning
Current drawings
60
Already outstanding
Undrawn commitment
40
Available under the stipulated facility
Additional drawings assumed at default
20
Half of the undrawn amount
Estimated EAD
80
Current drawings plus assumed additional drawings
Total limit
100
The facility ceiling
Synthetic USD million facility: drawn 60 and undrawn 40; a stipulated 50% conversion adds 20, yielding estimated EAD 80.
Original synthetic facility in USD millions. The model holds the current drawings and limit fixed and assumes half the undrawn commitment becomes outstanding before default. The 50% factor is illustrative.
The estimate is neither the current 60 nor automatically the whole commitment of 100. Within this simplified model, zero conversion gives EAD 60 and full conversion gives EAD 100. The realised balance at a later default could differ from the estimate.
In regulation, a credit conversion factor (CCF) converts an off-balance-sheet commitment into an exposure amount. Applicable factors, estimation permissions and floors depend on the regulatory approach and instrument. The 50% above is an assumption, not a claim about a universal regulatory factor. Basel CRE32 treats drawn amounts and undrawn commitments separately.
Recovery comes after the exposure basis
Suppose the example's exposure at default is 80 and net recovery, expressed at that same default valuation date, is 40% of that exposure. Recovery is 32 and the loss is 48 USD million:
80−0.40(80)=48.
The EAD remains 80 under this gross-exposure convention. Calling 48 the EAD would confuse the exposure with the loss after recovery. If recovery arrives later, its valuation date, discounting and costs must be specified before comparing it with the default-date exposure. Likewise, a loan's discounted market price need not equal its contractual balance or its EAD. State whether accrued interest and fees enter the exposure basis.
A derivative exposes a claim, not its notional
For a single uncollateralised derivative under a clean, immediate close-out convention, let Vτ be its signed replacement value to the surviving bank at the counterparty's default time τ. Its positive claim is
Eτ=max(Vτ,0).
A swap with notional USD 100 million and positive replacement value USD 3 million exposes a claim of 3 million under this convention. If its value is minus 3 million, this positive claim is zero; the bank's obligation to pay does not disappear. Close-out netting and collateral can change the relevant residual claim.
That default-time claim is distinct from an average future exposure, a percentile exposure or a regulatory EAD. For example, Basel SA-CCR combines replacement cost and a prescribed potential-future-exposure component with a multiplier at netting-set level. It does not simply use the trade's notional or today's positive value. The Exposure profiles lesson develops signed values, positive claims, means and percentiles in detail; the full lesson requires membership and has a public preview.
For any EAD number, retain the instrument, currency, valuation date or horizon, drawdown assumptions, netting set and collateral treatment. Those conventions determine what the number measures.
Sources
McNeil, A. J., Frey, R. and Embrechts, P. (2015). Quantitative Risk Management: Concepts, Techniques and Tools, revised edition. Princeton University Press, §10.1.5, pp. 372–373.
