This encompasses both the likelihood of the counterparty defaulting as well as possible recovery rates in the event of a default. Credit exposure arises in many situations and is managed in a variety of ways. For example, securities lending creates credit exposure because the borrower of a security may fail to later return the security. That risk is typically reduced through collateralisation .
Settlement risk entails very large credit exposures which last for brief periods of time.
Traditionally, credit exposure arose from lending activities, and was measured as simply the book value of all outstanding obligations from a counterparty. A bank would take credit risk when it issued a loan. An insurance company would take credit risk when it purchased a corporate bond. The pre-settlement risk of derivative instruments has made the task of measuring credit exposure more difficult. The notion of book value is not meaningful for most derivatives.