I'm a software developer want to know a little about quant basics. My undserstanding of PFE is that a PFE of a trade at a future time point is commonly defined by taking the average of the highest (or worst) 10% exposure of, say, 2000 projections calculated from curent value of the contract using a model and implied volatility. May someone tell me why the highest exposures are seen as "worst" exposures? Isn't a higer value of the contract with the counterparty a good thing for us?
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2 Answers
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Potential future exposure (PFE) is a concept in credit analysis, that is we are investigating the risk that a counterparty will not be able to pay us in the future.
In a typical derivative deal between two parties (for example a swap) when the deal is opened the value is zero, so neither party owes anything to the other.
However as time passes one of the parties will see the value of their position become positive (say +X) while the other party will have a negative value (-X).
For example suppose your view was that interest rates would go up over the next year, while the counterparty bet that they would go down. Suppose interest rates begin to climb month after month. It appears that you were correct and you will be owed a large sum by the counterparty at maturity. However, suppose the counterparty announces that due to losses on other positions they are going out of business and will not be able to pay you. Then the value of your lucrative derivatives deal will vanish and go to zero.
The bigger the value of the deal at the time of default, the bigger will be your loss from counterparty default.
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The higher the value of the contract, the higher the counterparty credit risk the bank's is taking from that contract. That's why banks set PFE limits to each counterparty.
