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Potential Exposure: The Long View on Credit Risk

Tools for measuring credit risk.
Fortnightly Magazine - May 15 2002
  1. line in Figure 3 represents a possible path that the MTM value could take. In some cases, the points on the lines are positive (representing a positive MTM value on the position), and in some cases the points on the lines are negative. In yet other cases, the MTM value switches back and forth between positive and negative. The more time that passes, the greater the range of possible price movement and the larger the range of possible MTM values.
  2. As the deal gets closer to maturity, the MTM value returns toward zero. This is because the MTM value of deal is a function not only of possible changes in market price, but also of the number of remaining contractual cash-flows stipulated by the deal. (Other types of derivatives can give rise to other "shapes" of potential exposure over time.)
  3. In the context of credit risk, the potential exposures that are of concern are the positive exposures depicted in Figure 4.
  4. When evaluating the amount of credit exposure generated by a deal, future negative MTM values are treated as equal to zero credit exposure.
  5. The Expected Potential Exposure (EPE) of the swap contract is the average of the remaining possible MTM values, treating negative values as zero. It is an important measure of potential exposure that figures into the analysis of capital adequacy.
  6. The Maximum Likely Potential Exposure (MLPE) of the contract is a "worst case" measure calculated to some acceptable confidence interval.

This measure indicates to executives how certain they can be that the loss from a counterparty will not exceed the MLPE value. For example, a firm might decide to calculate the number to a 95 percent confidence interval, which is consistent with most market risk VaR calculations. In this case, executives can feel confident that in 95 cases out of 100 the loss that they experience will not exceed the figure for MLPE generated by their model.

The accepted approach to calculating potential exposure in the financial derivatives and banking markets must be adapted to take account for significant additional challenges in the energy industry. Specifically:

  • Financial derivatives market participants have simpler netting requirements. This is particularly the case for energy companies that trade in both physical and financial contracts.
  • Energy markets are shaped by a much larger number of risk factors than the financial derivatives markets.
  • Energy market risk factors typically possess troublesome price behaviors (e.g., price jumps) that are often compounded by illiquidity concerns.
  • Contract portfolios of energy firms typically contain many highly structured and long-dated trades, often with large doses of embedded optionality written into them. This is particularly true of energy trading and marketing firms, but it is also the case for firms that hold energy assets. Each of these issues requires careful consideration when an energy company seeks to develop its own way to model potential credit exposure.

Potential Exposure Applications

The driving force behind the creation of a potential exposure model at most energy firms is the desire to enhance a set of key management tools and applications.

While each of the applications