White Papers
HOW TO CALCULATE POTENTIAL FUTURE EXPOSURE: A GUIDE TO BEST PRACTICE
At the end of May 2011, the International Swaps and Derivatives Association (ISDA) published new analysis of the over-the-counter (OTC) derivatives markets. While the analysis showed a 12% decilne in the notional outstanding, from $475 trillion in 2007 to $419 trillion in 2010, this decline does not necessarily indicate a change in the OTC derivatives market. Conrad Volstad, ISDA CEO commented that portfolio compression had had a significant impact on outstanding volumes as market participants looked to reduce credit risk, adding that the industry's collaborative work on documentation, netting and collateral was also having a 'major impact' in reducin risk in the market.
The use of practices like portfolio aggregation, collateral and netting clearly demonstrates the ongoing importance to banks of accurate exposure measurement in calculating their counterparty credit risk.
For OTC derivatives, this quantification is also known as potential future exposure (PFE). PFE quantifies the counterparty risk/credit risk by evaluating trades already done against possible market prices in the future, over the lifetime of the transactions. PFE is also a building block for credit valuation adjustment (CVA), another activity which drives regulatory work.
Much has been written on the theory of PFE, but it is about much more than theory. Over the last decade, banks have made significant investments in hardware, software and operations, building ever-more sophisticated PFE measurement systems. Throwing increasing amounts of technology at this area, however, will not in itself provide the total solution.
We propose a pragmatic approach to the calculation of PFE for off-balance-sheet OTC derivatives, providing guidance for the best approach to use.
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