Counterparty Credit Risk and Credit Value Adjustment: A Continuing Challenge for Global Financial Markets, 2nd Edition

9.1 Introduction

In this chapter, we present an overview of the various methods to quantify exposure. These vary from the simple but crude to the more complex generic approach of Monte Carlo simulation. This latter approach forms the majority of the discussion, as it is the most complex and has rapidly become a standard. We will define, in detail, the methodology for exposure quantification via Monte Carlo simulation, including a discussion of the approaches to modelling risk factors in different asset classes and their co-dependencies.

To illustrate many of the concepts here and in the previous chapter, we will then show a number of real examples, looking in particular at the impact of netting and collateral as well as other relevant effects.

At the heart of the problem of quantifying exposure lies a balance between the following two effects:

• As we look into the future, we become increasingly uncertain about market variables. Hence, risk increases as we move through time.
• Many financial instruments have cash flows that are paid over time, and this tends to reduce the risk profiles as the instruments “amortise” through time.

Nevertheless, the practical calculation of exposure involves choosing a balance between sophistication and operational considerations.