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

9.2 Methods for Quantifying Credit Exposure

9.2.1 Add-Ons

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:

• the time horizon in question;
• the volatility of the underlying asset class.

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:

• the specifics of the transaction in question (currency, specifics of cash flows);
• if the transaction has a mark-to-market very far from zero (other than the addition of this mark-to-market when it is positive);
• netting;
• collateral.

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 ...