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Potential Exposure: The Long View on Credit Risk

Tools for measuring credit risk.
Fortnightly Magazine - May 15 2002

Expected Potential Exposure (EPE), answers the question: "How large can I expect my exposure to this counterparty to become over the relevant time horizon?" EPE is useful for applications like capital adequacy and deal pricing where a portfolio of counterparties dampens the effect of the loss from any single counterpart. The relevant time horizon for EPE extends to a year or even longer. The second measure, Maximum Likely Potential Exposure (MLPE) answers the question: "What is the most I could lose to this counterparty with some degree of confidence (e.g., 95 percent) over the relevant time horizon?" MLPE is similar to the market risk metric of value at risk (VaR) and is handy for limit setting and stress testing to contain the effects of "the next Enron." For limit setting the relevant time horizon for MLPE can extend to deal maturity, while stress-testing horizons are typically less than a year but longer than the single-day horizon common to a typical VaR framework.

Some energy companies have begun to recognize the importance of potential exposure in their credit risk management frameworks. When these companies have applied potential exposure methodologies, they have naturally borrowed heavily from the accepted practices for measuring derivative counterparty exposure in the financial markets. This is a step in the right direction, but it is not sufficient. Practices borrowed from the financial markets must be adapted to cope with the unique characteristics of counterparty exposure within the energy sector. A good example of where improvements to this approach must be made is highlighted in Figure 2, where the extreme volatility in natural gas prices during the California crisis last summer rapidly converted potential exposures associated with long-term contracts into actual exposures (and in some cases real losses). Here the price swings erupted so quickly and were so extensive that financial market models failed to predict the extent of the damage (i.e., they severely underestimated potential exposure prior to the crisis). To avoid being bloodied by actual losses in the next crisis, energy companies must adopt forward-looking potential exposure measurement techniques using models that are appropriate to their markets. The remainder of this paper focuses on how potential exposure is measured and describes five key ways that it can be employed to better control credit risk.

Potential Exposure- A Calculation Primer

For a company to protect itself from a credit loss, it must first be capable of assessing its exposure to a given counterparty before default. As we discussed above, this exposure is not simply the netted sum of all the current mark-to-market (MTM) values of the trades with a particular counterparty, plus some outstanding receivable balance. We must also take into account how large a particular exposure might grow to over some relevant time horizon. Figure 3 illustrates this concept of potential exposure with regard to a two-year swap contract for natural gas.

  1. At origination of the deal (assuming it is priced at the money) the MTM value is zero.
  2. Over time, however, natural gas prices vary and, as a consequence, the MTM value of the contract will change. Each