LO 32.1: Differentiate am ong current exposure, peak exposure, expected exposure, and expected positive exposure.
The concept of counterparty credit risk (CCR) and its measurement and management gained prominence in the 1990s, and it now forms a critical part of most organizations risk governance. Financial institutions incorporated CCR through analyzing their derivatives exposures and by tracking the current exposure to their counterparties. Institutions measured regulatory capital for CCR as add-ons to current exposures, calculated as a percentage of gross notional derivatives values.
With the rise in importance of measuring CCR, modeling CCR also evolved. Initially, potential exposure models were used to measure and limit CCR. This approach evolved into expected positive exposure models, which allowed derivatives to be incorporated into portfolio risk models along with loans. The measurement of CCR also formed the basis for regulatory capital under Basel II and allowed for the incorporation of credit mitigants into risk modeling, including netting agreements.
There are four important definitions of exposure measures:
Current exposure. Also called replacement cost, current exposure is the greater of (1) zero or (2) the market value of a transaction (or a portfolio of transactions) that would be lost if the counterparty defaulted and no value was recovered during bankruptcy. Peak exposure. Peak exposure measures the distribution of exposures at a high percentile (93% or 99%) at a given future date prior to the maturity of the longest maturity exposure in the netting group. Peak exposure is usually generated for many future dates.
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Topic 32 Cross Reference to GARP Assigned Reading – Siddique and Hasan, Chapter 4
Expected exposure. Expected exposure measures the mean (average) distribution of exposures at a given future date prior to the maturity of the longest maturity exposure in the netting group. Expected exposure is also typically generated for many future dates. Expected positive exposure (EPE). EPE is the weighted average of expected exposures over time. The weights represent the proportion of individual expected exposures of the entire time interval. For the purposes of calculating the minimum capital requirement, the average is measured over the first year or over the length of the longest maturing contract.
One of the issues with CCR is wrong-way risk. Wrong-way risk is the risk that the exposure from a counterparty grows at the same time that the risk of default by the counterparty increases. Note that wrong-way risk does not arise with fixed-rate loans.
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