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Because losses from credit risk take a relatively long time to evolve, a more useful measure of exposure is potential exposure. Potential exposure is not like current exposure. It exists in the future and therefore represents a range or distribution of outcomes rather than a single point estimate.
Fundamentally, to assess the safety of a bank's asset portfolio and the adequacy of its Tier 1 capital and Tier 2 capital , one needs to evaluate whether it is resilient under severely stressing market moves. Because PFE is a measure of credit exposure, the most relevant stress move for PFE are not those where a large trading loss occurs as they are when considering an institution's market risk.
Instead, the scenarios of significant PFE can often be where the institution makes a large "paper" profit with a counterparty ; and therefore accrues a large unsecured claim on that counterparty a claim that the counterparty may be unable to pay. For example, a trader might buy cheap insurance contracts against a rare but catastrophic risk. The vast majority of the time — and for many years running — the trader will make a small annual loss the CDS premium even if the trade has positive expected value.
When the rare event occurs, the trader may suddenly have a huge windfall "profit" claim against whoever wrote the "insurance". And this would mean a sudden increase in the relevance of whether or not the 'insurance writing' counterparty can actually pay. The possibility that the counterparty cannot pay this huge new claim would create a systematically important difference between the theoretical-credit-risk-free profits of the trader and his institution and his realized year end profit. Since institutional market risks are hedged, this difference could impact the institution's capital not merely as a failure to make excess profits, but actually as a significant net loss due to losses on the offsetting hedge position.
And potentially, exposure to such credit losses could make the "profit-making" trader's institution fail and default on its own obligations to other companies thereby causing other companies to suffer credit risk losses and fail in the same way.
The theoretical potential for a cascading series of institutional failures caused by sudden rises in PFE is apparent. The cost of avoiding or dealing with these risks can fall on the public the vast majority of whom will not gain directly from the institutional profits made while accruing large PFE claims. This is for two main reasons. First, government directly or indirectly insures many retail deposits to prevent bank runs and to promote savings , and many quasi-government agencies e.
We first estimate the value of the swap for both counterparties, the customer and the bank at time zero. To keep our calculations simple we ignore the impact of discounting time value of money in our valuation model. We just do a simple addition of cash flows for both the fixed rate receiver and the floating rate receiver. Also, this set of calculations is done using the original yield curve and implied forward rates at time zero.
At time zero the mark to market valuation of the swap is USD , for the counterparty and USD , in favor of the bank. At time one the mark to market valuation of the swap is USD , for the counterparty and USD , in favor of the bank. The change happens because the first leg highlighted has been settled and is no longer included in future cash flows.
You can clearly see the flip in MTM from one leg to the next. We now repeat this process for the life of the transaction or the next four legs. Putting it all together we get the trend for the exposure across the life of the transaction at current rates. Within the table below you can see both sides of the transaction.
The counterparty which is us as well as the bank the seller of the swap. For the rates used and the swap structure in question, it appears that after the first leg, it will be the counterparty that will be exposed to the bank, rather than the other way around. While the counterparty may be in the money using the initial term structure that can quickly when the interest rate environment changes.
The graph above represents one possible future where we trace the exposure of the counterparties across the life of the swap. Here is another path for the same transaction, calculated, plotted and tracked in a similar fashion, but for a different yield curve. Compared to the first path this future takes a very different trajectory as well as a significantly larger peak exposure on year three.
The PFE process essentially requires the ability to generate such paths, tabulate results using MTM valuations for a transaction on the path and then compiling peak exposures across all paths across the life of the transaction.
If we take this concept forward using a short sample of three paths, here is what our world would look like with the third and final path. Compiling the three paths together in the table below we see that from the point of view of the counterparty us our primary exposure to the bank ranges between zero Path three to USD 12 million Path two.
This is our PFE estimate using our three paths sample world. While the three path approach is only illustrative, an actual PFE calculation exercise will follow a similar approach. However, rather than stopping at 3 paths, it would generate thousands of interest rate scenarios, calculate implied forward rates, estimate peak exposure and then pick the worst case peak exposure from the universe of all paths. The notional amount on the swap is USD ,, For each interest rate swap in our portfolio we would need to: Identify points of interest settlement dates or legs.
Identify net exposure at points of interest. At each point estimate worst case market shocks for a given confidence level include both normal and stressed conditions. Mark to market the transaction at points of interest.
Plot positive MTM exposure at points of interest.
|Potential future exposure definition||The market value is uncertain and can vary over time with the movement of underlying market factors. PFE is an important measure in evaluating potential risks and, together with effective regulation, may have been able to identify the Black Swan trades that have been behind most major collapses of the past 30 years, including Enron, AIG and Lehman. Capital System status. Quiz Are you a words master? The problem with this focus is that it places excessive emphasis on the present and fails to provide an acceptable indication of credit risk at some point in the future.|
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|Potential future exposure definition||Forex expert advisor ea|
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