The simplest approach to approximate future exposure is to take the current positive exposure and add a component that represents the uncertainty of the PFE in the future. This type of approach is highly simplistic and forms the basis of the Basel I capital rules (discussed in Section 17.3.1), often known as the “current exposure (CEM)” approach. At the trade level, the “add-on” component should account for:
For example, longer time horizons will require larger add-ons, and volatile asset classes such as FX and commodities should attract larger add-ons. Add-on approaches are fast and allow exposures to be pre-calculated and distributed via simple “grids”. Such grids allow a very quick look-up of the PFE impact of a new trade.
However, an add-on approach does not typically account for more subtle effects, including:
It is difficult to incorporate such effects except with rather crude rules (for example, Basel I allows 60% of current netting benefit to apply to future exposure). More sophisticated add-on methodologies have been developed (e.g., Rowe, 1995; Rowe and Mulholland, 1999), although the increased complexity ...