{{Unreferenced, date=March 2007 Potential future exposure (PFE) is the maximum expected

credit exposure Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...

over a specified period of time calculated at some level of confidence (i.e. at a given

quantile In statistics and probability, quantiles are cut points dividing the range of a probability distribution into continuous intervals with equal probabilities, or dividing the observations in a sample in the same way. There is one fewer quantile th ...

). PFE is a measure of

counterparty A counterparty (sometimes contraparty) is a legal entity, unincorporated entity, or collection of entities to which an exposure of financial risk may exist. The word became widely used in the 1980s, particularly at the time of the Basel I deliberat ...

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

. It is calculated by evaluating existing

trade Trade involves the transfer of goods and services from one person or entity to another, often in exchange for money. Economists refer to a system or network that allows trade as a market. An early form of trade, barter, saw the direct excha ...

s done against the possible

market price A price is the (usually not negative) quantity of payment or Financial compensation, compensation given by one Party (law), party to another in return for Good (economics), goods or Service (economics), services. In some situations, the pr ...

s in future during the lifetime of transactions. It can be called

sensitivity of risk Sensitivity may refer to: Science and technology Natural sciences * Sensitivity (physiology), the ability of an organism or organ to respond to external stimuli ** Sensory processing sensitivity in humans * Sensitivity and specificity, statistica ...

with respect to market prices. The calculated expected maximum exposure value is not to be confused with the maximum credit exposure possible. Instead, the maximum credit exposure indicated by the PFE analysis is an upper bound on a

confidence interval In frequentist statistics, a confidence interval (CI) is a range of estimates for an unknown parameter. A confidence interval is computed at a designated ''confidence level''; the 95% confidence level is most common, but other levels, such as 9 ...

for future credit exposure. Credit risk managers have traditionally remained focused on current exposure measurement (i.e., current

mark-to-market Mark-to-market (MTM or M2M) or fair value accounting is accounting for the " fair value" of an asset or liability based on the current market price, or the price for similar assets and liabilities, or based on another objectively assessed "fair ...

exposure, plus outstanding receivables) and collateral management. 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. 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 In statistics, point estimation involves the use of sample data to calculate a single value (known as a point estimate since it identifies a point in some parameter space) which is to serve as a "best guess" or "best estimate" of an unknown popu ...

Relevance

PFE is essential to

bank regulation Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they ...

under

Basel III Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response to ...

and Dodd Frank. Fundamentally, to assess the safety of a bank's asset portfolio and the adequacy of its

Tier 1 capital Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view.By definition of Bank for International Settlements. It is composed of ''core capital'', which consists primarily of common stock and disclosed res ...

(and

Tier 2 capital Tier 2 capital, or supplementary capital, includes a number of important and legitimate constituents of a bank's capital requirement.By definition of Bank for International Settlements. These forms of banking capital were largely standardized in t ...

), 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 Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most ...

). Instead, the scenarios of significant PFE can often be where the institution makes a large "paper" profit with a

; 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 Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge ...

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 The compact disc (CD) is a digital optical disc data storage format that was co-developed by Philips and Sony to store and play digital audio recordings. In August 1982, the first compact disc was manufactured. It was then released in Octo ...

premium) even if the trade has positive

expected value In probability theory, the expected value (also called expectation, expectancy, mathematical expectation, mean, average, or first moment) is a generalization of the weighted average. Informally, the expected value is the arithmetic mean of a l ...

. 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.g.:

FNMA The Federal National Mortgage Association (FNMA), commonly known as Fannie Mae, is a United States government-sponsored enterprise (GSE) and, since 1968, a publicly traded company. Founded in 1938 during the Great Depression as part of the N ...

Freddie Mac The Federal Home Loan Mortgage Corporation (FHLMC), commonly known as Freddie Mac, is a publicly traded, government-sponsored enterprise (GSE), headquartered in Tysons Corner, Virginia.depression. One plan that is intended to reduce the public cost (& private benefit) of the implicit support to "

too big to fail "Too big to fail" (TBTF) and "too big to jail" is a theory in banking and finance that asserts that certain corporations, particularly financial institutions, are so large and so interconnected that their failure would be disastrous to the great ...

" institutions is to reduce the variability and scale of PFE by incentivizing

collateralization In medicine, collateralization, also vessel collateralization and blood vessel collateralization, is the growth of a blood vessel or several blood vessels that serve the same end organ or vascular bed as another blood vessel that cannot adequately ...

Expected exposure

The expected exposure (EE) is defined similarly to the PFE, except that the average is used instead of a specific quantile. The EE represents the estimated average loss at a specific future point of time that a lender would suffer from if the borrower (counterparty) fully defaults on his debt (i.e. if the loss given default (LGD) was 100%).

External links

– Basel III, International Regulatory Frameworks for Banks. Credit risk Financial risk Investment Monte Carlo methods in finance

Relevance

Expected exposure

See also

External links