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Potential Exposure: The Long View on Credit Risk

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

in Figure 5 can be addressed without an appropriate potential exposure model, the quality of the results is heavily dependent on the exposure input. Here is how a forward-looking potential exposure model improves these applications:

  • Most responsible energy firms want to make sure that the risks they are running are in line with the risk capital that they have available. This means making use of a key risk concept known as 'economic capital', which is the amount of capital that a firm should hold to protect itself from insolvency to a given degree of confidence over a specific time interval (typically set at one year). It is an increasingly important risk metric because it creates a common denominator of risk across risk types (e.g., market, credit, business). What matters most when calculating economic capital is the expected level of losses, and the volatility of those losses. To compute the amount of economic capital that a firm needs to cover its credit risk, the firm must be able to predict its expected potential exposure at the one-year horizon, and better still, to do so using a model that also predicts the volatility of that exposure.
  • As Enron began its descent into bankruptcy, the risk managers at the energy giant's many counterparties had one question at the top of their minds: "What is my current exposure to Enron?" Measures of current exposure are clearly useful in such a situation, but two problems often exist. First, managers often have a difficulty getting hold of timely exposure measures. Second, even when current exposures are measured, the positions that create them cannot be instantly unwound. Recognizing these two problems, the more alert managers were asking a different question: "How big could my exposure to Enron become over the next month?" When a counterparty's credit quality rapidly begins to deteriorate, a model that is capable of measuring both expected and maximum likely potential exposure over an adjustable time horizon is a valuable tactical asset.
  • In the wake of the Enron collapse, liquidity management is being viewed with an increased sense of urgency. It can be complicated to work out the liquidity profile over time for a complex energy portfolio. For example, financial transactions will often have margin requirement provisions, whereas physical transactions generally do not. A model of potential exposure that carefully accounts for the differences in margining requirements between various transactions can be employed to improve the predictability of short-term cash needs. Furthermore, it can offer early warning of any potentially large margin-calls that might threaten a firm's liquidity in the medium term.
  • Few would deny that the presence of credit risk in a transaction generates a cost. A model similar to the one that calculates Economic Capital over one-year can be employed to calculate the cost of credit risk over the entire life of a transaction. The key input for this model is the figure for the potential credit exposure of an energy contract, and the volatility of that exposure over the entire life of the transaction. Once the cost of the credit risk has been