Michael Jacobs Jr., PhD, CFA1
Pricewaterhouse Cooper Advisory LLP
A bank's counterparty credit risk (CCR) exposure quantifies how much money the counterparty might owe the bank in the event of default. The CCR quantity is broken down into current exposure (CE), which measures the exposure if the counterparty were to default today, and potential exposure (PE), which measures the potential increase in exposure that could occur between today and some time horizon in the future.
The time of default is typically modeled as a stochastic stopping time. As opposed to the known CE, the PE must be estimated, usually by simulation. First, the expected positive exposure (EPE) is computed by simulating a large number (on the order of 102 to 103) of different paths for the various underlying future prices in the possible market environments, using a so-called regularized variance-covariance matrix. Then the system prices each of the derivative transactions on each path for each sample date,2 computes collateral call amounts based on relevant marked-to-market (MTM) calculations, applies the portfolio effects of netting and collateral, and aggregates exposure results to compute the average exposure along a term structure.
While an EPE may be a good indicator of the cost to replace a contract should the counterparty default, EPE is not helpful in the trade inception ...