HOW TO CALCULATE POTENTIAL

FUTURE EXPOSURE
A GUIDE TO BEST PRACTICE
White paper
By DR. Ulrich Schanz and Michel Dorval, Misys, July 2011
How to calculate potential future exposure: A guide to best practice

CONTENTS

1.0 EXECUTIVE SUMMARY 3

2.0 PFE INSIGHT 4

2.1 Background 4
2.2 The need for a practical approach 5

3.0 DIFFERENT METHODS 6

3.1 Add-on method 6
3.2 Simulation method 6
3.3 Combination of add-on and simulation methods 6

4.0 HOW TO DETERMINE THE ADD-ON 7

4.1 Basel CEM 7
4.2 Basel SA 8
4.3 Basel IMM 8
4.4 Add-on through stress testing 10
4.5 Add-on via historical simulation 11

5.0 CHOOSING THE RIGHT METHOD 13

6.0 CONCLUSION 15

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How to calculate potential future exposure: A guide to best practice

CHAPTER 1.0
EXECUTIVE SUMMARY

At the end of May 2011, the International Swaps and Derivatives Association (ISDA)
published new analysis of the over-the-counter (OTC) derivatives market. While
the analysis showed a 12% decline in the notional outstanding, from $475 trillion in
2007 to $419 trillion in 2010, this decline does not necessarily indicate a change in
new OTC derivatives market. Conrad Volstad, ISDA CEO commented that portfolio
compression had had a significant impact on outstanding volumes as market
participants looked to reduce credit risk, adding that the industry’s collaborative
work on documentation, netting and collateral was also having a ‘major impact’ in
reducing risk in the markets.1

The use of practices like portfolio aggregation, collateral and
netting clearly demonstrates the ongoing importance to
banks of accurate exposure measurement in calculating their
counterparty credit risk.
For OTC derivatives, this quantification is also known as
potential future exposure (PFE). PFE quantifies the
counterparty risk/credit risk by evaluating trades already
done against possible market prices in the future, over the
lifetime of the transactions. PFE is also a building block for
credit valuation adjustment (CVA), another activity which
drives regulatory work.
Much has been written on the theory of PFE, but it is about
much more than theory. Over the last decade, banks have
made significant investments in hardware, software and
operations, building ever-more sophisticated PFE
measurement systems. Throwing increasing amounts of
technology at this area, however, will not in itself provide the
total solution.
We propose a pragmatic approach to the calculation of PFE
for off-balance-sheet OTC derivatives, providing guidance
for the best approach to use.
Our contention in this paper is that in certain cases the
optimal choice is not necessary the most advanced method.
From a practical, day-to-day operational point of view, the
best approach is a combined approach. Like this banks
should reserve advanced techniques such as Monte Carlo
simulations for the larger and more complex exposures (in
other words, apply these techniques where they bring real
value), and use analytical methods for other exposures.
We present methods that combine simulation and add-on
approaches and consider possible alternative methods,
such as add-on via historical simulation and stress testing,
providing practical examples of each. In the case of
structured products, for example, neither the relatively basic
regulatory approach nor the more advanced method
provides an optimal balance.
In setting out the considerations that must be made, we
hope to suggest the most efficient way of calculating
exposure and economic capital using advanced simulation
techniques, taking into account the specific situation within
a specific organization.

1
ISDA, OTC Derivatives Market Analysis Year-end 2010, May 2011. White paper 3
How to calculate potential future exposure: A guide to best practice
CHAPTER 2.0
PFE INSIGHT
2.1 Background
Thirty years ago, credit risk managers focused principally on
current exposure measurement. This meant that financial
products were measured mainly on a nominal or notional
basis. With the rise in derivatives trading, however, it became
evident that this approach did not provide an acceptable
indication of credit risk because losses from credit risk took a
relatively long time to evolve for swaps, options and other
such forward instruments. There were two main reasons for
this: firstly, exposure became a function of the market value
of the derivative at the time of default; secondly, the impact
of market rate volatility could lead to much higher exposures
later on in the life of the contract.
A more useful measure, therefore, was the ‘mark-to-market
plus add-on’ approach. This add-on represented a potential
exposure and a range or distribution of outcomes rather than
a single point estimate. This approach, which was also driven
by Basel I, was simple, fast and fairly accurate. It worked well
for derivative stand-alone deals but had clear shortcomings
in the case of complex products, portfolio netting and
advanced collateral management. These are explained
further in Chapters 3 and 4.
Hence the move to full Monte Carlo simulation of
counterparty exposure, specifically for off-balance-sheet
derivatives. Over the last ten years, this has provided a
primary reference, not only for managing risk limits, but
also for calculating regulatory capital, as pushed by the
Basel II framework. The calculation of PFE requires a
multi‑step Monte Carlo simulation, where different
scenarios describe the joint evolution paths of all of the
market factors affecting exposures and collateral. Monte
Carlo simulation is the most accurate, generally applicable
and reliable way of capturing the complex, stochastic
nature of PFE (such as its optionality) as well as modelling
collateral and netting to reduce exposure.
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When considering the correct PFE approach to adopt,
banks need to address a number of challenges:
The data integration challenge
Different types of market data, trades or even netting
agreements require the cooperation of various banking
departments. An inability to achieve this cooperation has,
in the past, contributed to the failure of some financial
institutions to progress to a simulated PFE model.
The quantity and complexity of data
This can be a deciding factor for the banks. Some of
their counterparties are actually part of larger groups,
consisting of separate legal units and with subsidiaries
in different countries. This leads to complex netting and
collateral arrangements. The growing complexity of
financial contracts and business relationships has produced
more intricate transactions and hence added to the banks’
computational burden.
The need to react quickly to changes in the
business environment
The pace of activity in the business environment has
increased significantly and to stay ahead of the game
the business side of the bank has to make rapid,
accurate decisions.
In systems terms, this means that whereas a few years ago
a nightly batch may have been entirely sufficient to monitor
the bank’s exposure, today’s solutions must provide intra-day
decision support. At the same time the banks IT teams are
under constant pressure to add end-to-end coverage for new
financial instruments to already complex infrastructures.
Budgets are limited, however, and risk management
departments, especially in smaller or regional banks, have
limited resources to devote to configuring and monitoring
complex simulations.
The solution therefore needs to be transparent and not too
demanding in terms of maintenance.
How to calculate potential future exposure: A guide to best practice

2.2 The need for a pragmatic approach
In addressing the challenges listed in section 2.1, banks
need to take account of best practice, but they also need
to focus on what will work best for their own organization.
This reflection is necessary and we demonstrate later why
the ‘one size fits all’ approach will fail.
The most sophisticated methodology currently available to
estimate possible future outcomes and calculate PFE as a
statistic is the full Monte Carlo simulation.
So, what are we advocating?
Our contention is that from a practical, day-to-day
operational point of view, the best approach is a combined
approach. Banks should reserve advanced Monte Carlo
simulations for the largest and most complex off-balance-
sheet exposures (in other words, apply these techniques
where they bring real value) and use analytical methods for
other exposures. We also present methods that combine
simulation and add-on approaches.

The discussion usually focuses on hardware, software and
performance: ‘How long does it take to complete a full run?’
or ‘How are intra-day increments measured?’
However one point frequently forgotten is that Monte Carlo-
based portfolio simulations also require a substantial
investment in human skills, if they are to be used effectively.
Without this expertise, the shiny technology risks becoming
a black box, producing a number that has little to do with the
true risk of the bank, and simply adding to its electricity bill.
Chapter 3 describes the different techniques available
in more detail. Chapter 4 details several methods and
examples for determining add-ons. Finally in Chapter 5
‘Choosing the right method’ we show how these
considerations will suggest the most efficient way
of calculating exposure and economic capital using
advanced simulation techniques, given the specific
needs of the organization.

The more traditional add-on methods have some drawbacks

too: they do not adapt as quickly to changing market
conditions; they are more approximate in modelling the
impact of credit risk mitigation techniques; and they
generally provide a higher exposure, and hence capital
requirement, since they are set to be more conservative.

For many types of exposure, however, these analytical

methods are fast, sufficiently transparent and largely
accurate enough. They provide a stable and reliable
methodology.

White paper 5
How to calculate potential future exposure: A guide to best practice
CHAPTER 3.0
DIFFERENT METHODS
3.1 Add-on method
The add-on method expresses the PFE as the sum of two
terms: the ‘current value’ and the ‘add-on’, with the latter
representing a possible future increase in the contract’s value
over today’s value.
In most frameworks the current value of the contract is
defined as its mark-to-market value, but it could also be the
book value, derived from the accounting systems.
There are several ways of estimating the add-on. It is
frequently calculated by multiplying the nominal amount of
the contract with a risk weighting which is selected from a
look-up table linked to some of the contract’s characteristics.
A practical discussion is included in Chapter 4.
Add-on methods are stable and reliable: they do not change
and are easy to convey to other parts of the organization.
Once set, they also require less maintenance than the full
simulation method described below. They consider netting
effects and risk mitigation through collateral, and as we
indicated earlier, while they are more approximate than a
correctly configured and monitored simulation process, for
most exposures analytical methods are fast, sufficiently
transparent and accurate enough.
3.2 Simulation method
The most accurate way of estimating PFE is to simulate the
underlying market data over the life of the portfolio and
price each contract at selected time steps as it matures.
Since the evolution of future market data is not deterministic,
Monte Carlo simulations are used to generate a large
number of possible paths, and PFE is calculated as a
statistic based on these outcomes.
The simulation method handles the full pricing of complex
contracts and the correct modelling of path-dependent
pay‑offs when the contracts are aged over their life.
Diversification and hedging effects within the netting
set are fully simulated and the method allows for a good
approximation of the effect of credit risk mitigation
provided by collateral agreements.
The main drawback is that the simulation method is both
data and computationally intensive. In addition to investing
in significant IT resources, the bank will also need to assign
functional experts to maintain the parameterization of the
engine and ensure that the results make sense.
Several precursors are required before any results can
be obtained:
• To prepare for Monte Carlo simulation the bank needs to
collect and clean a sufficiently long market data history.
The data aging models that will be used to generate the
range of possible future market data paths are calibrated
on this history and correlation matrices need to be
6 White paper
computed2. Significant time and effort needs to be
allocated to running and checking these calculations
because if the data entered into the system is poor, the
subsequent simulations will be meaningless.
• Once the parameterization has been done and approved,
the actual simulation can be run. The number of simulation
steps is determined by reporting requirements; the
number of paths depends on the convergence of the
Monte Carlo algorithm. It is important to carry out
periodic checks for convergence (this means verifying
that running the same simulation again leads to a similar
result), as convergence of the algorithm depends on
the characteristics of the portfolio and possibly also on
the current mark-to-market rates.
• A further challenge is that standard pricing libraries cannot
be reused without modification. Whereas most standard
pricing functions provide mark-to-market prices and
sensitivities, pricing for PFE must handle aging through
time and take into account the eventual path dependency.
Moreover, the pricing models used in the front-office
may be too slow for PFE simulation and have to be
approximated. They may need to be simplified, ideally
replacing numerical methods by closed form expressions.
A separate pricing function library suitable for PFE
simulation will therefore have to be maintained. This will
add cost and delay the time to market for new products,
especially if the latter are not standardized. This challenge
is particularly difficult to overcome for structured and
securitization products.
To recap, simulation methods are the most precise, however
they need to be configured correctly and monitored on an
ongoing basis. Both IT resources and functional experts are
required to maintain and develop the parameterization of
the engine in such a way that the simulations converge
numerically and the results can be explained to non-experts.
Banks must understand that the final figures are based on
models (models for evolving market rates into the future and
models for pricing the contracts) and that the assumptions
and simplifications on which these are based must be
checked and justified on an ongoing basis.
3.3 Combination of add-on and simulation
methods
The combined method involves fully simulating a contract or
several contracts in a netting set, then using the resulting
PFE profile to define add-ons. These add-ons can be stored
in look-up tables for re-use with the add-on method. In this
sense, the Basel III internal model method (IMM) is a
combined method. More details are provided in Chapter 4.
2
Correlation matrices can be very important in the case of large and well
diversified portfolios. Positively correlated risk positions tend to increase
credit exposures.
How to calculate potential future exposure: A guide to best practice

CHAPTER 4.0
HOW TO DETERMINE THE ADD-ON

Use of the add-on approach brings its own questions:
how do I set prudent but accurate add-ons? What is the
granularity of the add-ons? In other words, do I define
add‑ons by type of instrument, by currency, by maturity,
and/or by other criteria? How often should these add-ons
be reviewed?
This section describes a number of methods that can be
used to estimate the add-on for PFE. The methods differ
in levels of complexity.
The first three methods are based on the approach proposed
by the Basel II framework to calculate the exposure at default
(EAD) for OTC derivatives3.
We will not get embroiled in the details of the regulatory
capital calculation methodologies in this paper. Instead,
our aim will be to use them as a starting point for the
bank’s internal method.
4.1 Basel CEM
The add-on can be set using a method similar to the
Basel II current exposure method (CEM) for computing
EAD for OTC derivatives.
Add-on = delta adjusted effective notional X credit
conversion factor
According to the Basel II recommendation, the way the
credit conversion factor (CCF) is set depends on the
residual maturity and the type of underlying instrument.
The add-on in the example of the IRS is set as follows,
using CEM:
• Add-on = 100 000 000 EUR X 1.5% = 1 500 000
CCF is derived from the remaining maturity (more than
five years) and the type of instrument (interest rate risk).

The Basel methods are:

• Basel Current Exposure Method (CEM)
• Basel Standardized Approach (SA)
• Basel Internal Model Method (IMM)

Once we have considered the Basel methods, we will

introduce two further ways to determine the add-ons: by
applying specific ‘shocks’ to the underlying market factors.
These may be fully deterministic or may take scenarios from
a historical period, possibly a historical period of significant
stress. These methods are:
• Add-on through stress testing
• Add-on via historical simulation

These methods will be explained using the

following example:

A vanilla interest rate swap (IRS) with the following

characteristics:
• Client pays: 6 months Libor
• Client receives: 3% fixed
• Notional amount: 100 000 000 EUR
• Start date: 16 February 2011
• Maturity date: 16 February 2016

3
BIS, Basel II: International Convergence of Capital Measurement and Capital Standards: White paper 7
A Revised Framework – Comprehensive Version, Annex 4, June 2006.
How to calculate potential future exposure: A guide to best practice
4.2 Basel SA
In this instance, a method similar to the Basel II standardized
approach for computing EAD for OTC derivatives is used to
set the add-on.
For a single transaction the Basel formula is:
EAD = beta X max [current market value; deal adjusted
effective notional X CCF]
Hence:
Add-on = EAD – current market value
And, using the Basel SA to compute the add-on in the
example of the IRS
Basel II sets beta equal to 1.4 and recommends what the
credit conversion factors should be; for example, 0.3% for
low specific risk.
• EAD: 1.4 X max ( 2 373 207; 100 000 000 X 0.3%) =
1.4 X 3 000 000 = 4 200 000
• Add-on = 4 200 000 – 2 373 207 = 1 826 793
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4.3 Basel IMM
Here, the add-on is set using a method similar to the Basel II
internal model method for computing EAD for OTC
derivatives. The IMM is the most sophisticated of the three
Basel methods and assumes that the bank can run a full
simulation of PFE for the transaction, or set of transactions.
Its use for regulatory capital is subject to stringent
acceptance criteria.
The Basel II IMM formula defines EAD as:
EAD = alpha X Effective expected positive exposure (EPE)
Where:
• alpha = 1.4
• Effective EPE (EEPE) is the weighted average over time of
effective expected exposure (EEE) over the first year. EEE
at a specific date is the maximum expected exposure (EE)
that occurs at that date or any prior date. EE is the mean
(average) of the distribution of exposures at any particular
future date.
For regulatory capital purposes, the EEPE formula is time
weighted and calibrated to one year. In the more general
context of this paper, we can define it as follows:
EAD(t) = alpha X max(EEE(t), 0)
giving an exposure profile at a future time t.
Finally:
Add-on = EAD – Current Market Value
If Basel IMM is used to set the add-on in the example of the
IRS, then:
• EAD: alpha X EEE(t) = 1.4 X 4 007 854 = 5 610 995
• Add-on = EAD – Current Market Value = 5 610 995 –
2 373 207 = 3 237 788
Consider also the example of a range accrual swap, where
the notional amount is 10 million Euros. We receive a
structured coupon with a fixed rate of 5%, a lower barrier
of 0% and an upper barrier of 1.35% every six months,
and pay a floating coupon every three months, floating rate +
spread = –0.3%.
How to calculate potential future exposure: A guide to best practice

The resulting Potential Future Exposure (PFE) and the Expected Positive Exposure (EPE) profiles over time are shown in the
table below and plotted in the chart that follows:

DATE PFE EPE MAXIMUM PFE MAXIMUM EPE

2011-03-15 730 709.13 537 334.79

2011-11-16 2 477 097.17 852 505.22

2012-05-16 2 901 201.43 978 818.22

2012-11-16 3 081 113.03 1 046 240.93

2013-05-16 3 164 479.24 1 073 172.17 3 164 479.24 1 073 172.17

2013-11-16 3 155 149.35 1 068 090.14

2014-05-16 3 042 802.91 1 035 874.44

2014-11-18 2 892 177.48 982 331.10

2015-05-16 2 719 358.62 932 844.83

2015-11-17 2 412 562.70 829 998.69

2016-05-18 2 108 619.00 714 478.66

2016-11-16 1 671 567.49 565 901.57

2017-05-16 1 185 778.73 402 314.69

2017-11-16 631 497.77 213 281.85

2018-05-16 0.00 0.00

Table 1: Range Accrual Swap – Computed potential future and expected future exposures on future dates

3 500 000
Maximum PFE
3 000 000 PFE

2 500 000

2 000 000

1 500 000

Maximum EPE
1 000 000
EPE

500 000

0
-15 -16 -18 -16 -16 -16 -16 -18 -16 -17 -18 -16 -16 -16 -16
1 1 -03 11-11 12-05 12-11 13-05 13-11 14-05 14-11 15-05 15-11 16-05 15-11 17-05 17-11 18-05
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

Figure 1: Range Accrual Swap – potential future exposure and expected future exposure profiles over time

White paper 9
How to calculate potential future exposure: A guide to best practice

4.4 Add-on through stress testing
Using stress testing, the bank is able to estimate to what
extent the counterparty exposure could be increased under
specific, pre-defined ‘stress’ conditions. Stress-testing in
general refers to user-defined changes in the underlying risk
factors and measures their impact on transaction prices.
Define the add-on as present value PV(stressed) –
PV(mark-to-market), where:
• PV(stressed) is the theoretical price under stressed
market rates
• PV(mark-to-market) is the price using today’s market rates
When calculating the add-on for PFE, stress needs to be
applied to two areas:
• Market rates
• Deal structure
We define market rate stress as the expected or large move
(for example a move by 2.33 standard deviations4) of the
underlying market factor over the life of the contract. If there
are several underlying market factors, then a combination of
stress tests need to be run, either stressing each risk factor
in isolation or defining combined shifts. Deal sensitivities can
be used as guidance in constructing the stress scenarios.
The simplistic assumption made above is that the
outstanding amounts of the deal decrease over time; the
stress applied to the deal therefore reflects a maximum
increase in exposure. The deal can also be valued at a date
in the future by entering its future description as a simulated
deal. For more complex deals a more prudent approach
would be to decide which ‘form’ of the deal will have the
greatest future exposure, in other words, where will it have
the highest outstanding amounts. It may be necessary to
look at several versions of the deal, for example exercised/
non-exercised, converted/non-converted, today/mid-life/
maturity, and so on.

Applying the following stressed yield curves in the

example of the IRS, we obtain the P&L results shown in
the table below:

10

ST_UP5

8
YIELD

ST_UP
4 Today
ST_DN
ST_AZ

0
1W 1M 3M 6M 1Y 2Y 5Y 10Y 20Y
TENOR

Figure 2: Examples for stressed yield curves as compared to today’s yield curve

10 White paper 4
For market data that is normally distributed, a move by 2.33 standard
deviations will not be exceeded, 99% of the time.
How to calculate potential future exposure: A guide to best practice

As discussed in 4.4 above, in the case of stress tests, the deal

can also be valued at a date in the future by entering its
future description as a simulated deal. This is necessary if
the deal’s outstanding amounts do not decrease with time.

The add-on is defined as:

Add-on = VaR

In the IRS example, the results of a one day horizon historical

simulation are shown in the following figure. The P&Ls
for each of the scenarios are ranked from best to worst.
We are interested in the scenarios that give the biggest
simulated gain.
Figure 3: Profit or loss generated for each of the stressed yield curves

While the stress test ‘ST_UP5’ seems to be the most severe

(interest rates move up by 5% on the entire term structure)
it is actually ‘ST_AZ’ that leads to the biggest gain in the IRS’s
price and therefore produces the worst case exposure.

We can therefore set add-on = 3 294 406.45

4.5 Add-on via historical simulation

In a sense, historical simulation is a form of stress test. The
main difference is that the scenarios have been observed
historically and the correlations are implicit. This simplifies
the modelling of complex scenarios, compared with the
user‑defined stress test presented in the previous section.
The historical period chosen can be a recent one or can be
a period in the past that offers stress conditions relevant to
today’s portfolio.

It is important to decide which horizon to use and whether

or not to scale by the square root of time (time scaling) in
order to generate scenarios that are of an appropriate size
to simulate the rate changes that may occur over the life of
the deal.
Figure 4: Positive tail of the distribution of full valuation P&Ls as generated by
historical simulation

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How to calculate potential future exposure: A guide to best practice

The scenario in the P&L distribution that defines the cut-off for the 1% tail in gains is the one dated 15/03/20115.

Today
2011-03-15
3.75

2.5
YIELD

1.25

0
1W 1M 3M 6M 1Y 2Y 5Y 10Y 20Y
TENOR

Figure 1: Range Accrual Swap – potential future exposure and expected future exposure profiles over time

We can therefore set Add-on = 350 044.67

This add-on is the smallest of any calculated by the above

methods and probably underestimates the future exposure.
If we used a different historical period with higher volatility
or a longer simulation horizon, we would see a higher
add‑on.

12 White paper 5
 alculated from the historical shift observed between closing rates from
C
14 March 2011 to 15 March 2011.
How to calculate potential future exposure: A guide to best practice

CHAPTER 5.0
CHOOSING THE RIGHT METHOD

When calculating exposure using advanced simulation
techniques, every organization faces a number of constraints.
These were considered in Chapter 2.
This section will address how to choose the appropriate
methodology and will put forward criteria which could be
used in making this decision.
In short, the optimal solution for a bank needs to satisfy
two questions:
• Can I justify the figures obtained?
• Are these figures sufficiently risk sensitive?
Exposure figures are used to monitor the bank’s operations
and as a basis for decisions. The larger or more complex
an exposure, the more important it is that the risk manager
can justify the figure and explain how it was obtained.
Similarly, the larger or more complex an exposure, the more
important it is that the exposure measure adjusts through
time and differentiates between specific instrument and
counterparty criteria.
The ideal solution depends on an ability to apply different
approaches to different parts of the bank’s exposure:
to different netting sets or different counterparties, for
example. This follows from the fact that PFE profiles are
additive (i.e. equality holds in the below equation) if there
is no netting agreement between them. More precisely:
• It can generally6 be assumed that PFE_(A+B) ≤ PFE_(A) +
PFE_(B) for sets A and B of deals.
• Two PFEs are additive if there is no netting agreement
covering both deals in A and B, even if the underlying risk
factors are correlated.
The following table lists some of the possible decision
criteria that can be used by the bank to split the PFE
calculations for off-balance-sheet derivatives into smaller
parts. The latter can then be combined to produce the
overall exposure figure.

DECISION CRITERIA ESTIMATE PFE VIA ESTIMATE PFE VIA MONTE

ADD-ON LOOKUP CARLO SIMULATION

SIZE OF COUNTERPARTY Small overall exposure Exposure is in the top ten of all
counterparties

TYPE OF DEAL Deal has a linear payoff Deal has a complex pay-off
(path dependent, for example)

TEAM Small team handling various tasks Large team, with some members
dedicated as experts to configure
and monitor the credit risk solution

Table 2: Example decision criteria

These criteria are not independent. For example, the deal

may be based on a complex path dependent product, but
in the overall context its exposure is insignificant compared
with exposure to other counterparties. It might therefore
be sufficient to estimate the PFE for this deal using a simple
fixed add-on.

6
Depending on the quantile method that was applied to determine the PFE cut-off, the PFE White paper 13
measure may not strictly speaking satisfy subadditivity in some cases, but in practice this
can be ignored.
How to calculate potential future exposure: A guide to best practice

Some structured products present a particular challenge.

State‑of-the-art trading systems have flexible structuring
tools embedded within them. The flexibility that is now
available in the front-office is not, however, carried through
to the PFE simulator. From a technical point of view it is rarely
possible to plug these tools directly into a full, Monte Carlo-
based portfolio simulation. So, the bank needs to use a two
step approach: first, apply an add-on method in order to
approve the trade and include it in the daily process; then,
when available, move to a more complex approach for
monitoring it through its life cycle.

This add-on can be obtained via a combined approach:

the add-on is simulated via Monte Carlo and updated
periodically (say monthly), while the mark-to-market value
is updated daily.

A further challenge in the case of structured products may

be the computational time required; a simpler functional
model may not be acceptable to simulate the exposure.
This can be addressed by trying to tune the technical
framework (for example via gridification, cache memory, or
use of specialized hardware), but the hypothetical example
shown below demonstrates that this will not always provide
the answer:

Imagine that a single price takes one minute to

compute; the simulation requires 5000 paths and
30 time steps; and the maximum time window available
is four hours. Then (assuming linear scaling), only eight
paths can be run per processor core.

To provide the computing power for this single

deal, 625 processors would be required. To handle
120 deals of this type, the bank would require
75 000 cores – a situation which is just not feasible
in practice.

As in the previous example a suitable approach could

be a combined one, based on add-ons that are simulated
separately via Monte Carlo and updated periodically.

14 White paper
How to calculate potential future exposure: A guide to best practice

CHAPTER 6.0
CONCLUSION

Triggered by periods of extreme turbulence, credit failures

and regulatory initiatives, the ability to provide accurate
exposure measurement is still a vital aspect of the credit risk
manager’s role and much has been written on sophisticated
methods of measuring exposure.

What we wanted to achieve with this paper, however, was

to urge a more pragmatic approach to the implementation
of such methods across the entire banking operation.
We wanted to demonstrate how best practice could be
used to calculate exposures, to meet both regulatory and
performance requirements, and to show how a ‘one size
fits all’ approach is not appropriate.

Consequently, we showed how the more sophisticated

Monte Carlo simulation approach has its strengths but also
a number of drawbacks. The add-on method, while less
accurate than a simulation process, nevertheless has speed
and reliability in its favour.

We provided decision criteria that can be applied and

combined by the banks when working out their overall
exposure figure. These include the size of the counterparty,
type of deal and level of resources.

We considered the issues raised by structured products,

where challenges like computational time and the
integration of front office pricing need to be addressed.
A combined approach was discussed based on add-ons
that are simulated separately via Monte Carlo and
updated periodically.

Practical examples were provided to support our hypothesis:

an IRS and a range accrual, using add-on calculations which
followed the regulatory approach. Additionally, we proposed
two alternative methods of calculating the add-on: historical
simulation and stress testing.

In this way we have demonstrated why the optimal approach

for banks in calculating exposure is a combined approach:
applying Monte Carlo simulations for the largest and most
complex exposures where they bring real value, but using
analytical methods for other exposures.

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