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Potential Exposure: The Long View on Credit Risk

Tools for measuring credit risk.
Fortnightly Magazine - May 15 2002
  • identified, it can be built into the price of the transaction. Alternatively, management can at least make sure that it is aware of the cost of a deal in terms of foregone risk-adjusted profits if the cost cannot be passed on to the counterparty.
  • To be effective, a risk management program must offer a mechanism for limiting the size of a firm's exposure to its counterparties. Traditionally, such credit limits are tied to the credit rating of the counterparty, and are often identified in terms of the amount of exposure. For example, a firm might take on no more than $10 million of credit exposure to a counterparty that is rated BBB by the rating agencies. As we have seen, however, this limit is not sufficient if it is defined simply in terms of current exposure. It might even be dangerously misleading. For example, a swap contract that is struck at the current market price (i.e., at the money) has zero current credit exposure at the moment that the deal is done. Yet common sense, and the swap contract example that we discussed earlier, suggest that the forward-looking credit risk of the contract must be captured if the firm's system of credit limits is to function in an appropriate manner. Again, a model of potential exposure can provide an accurate measurement approach, and can also be adapted to provide advance warning of the need for any corrective action.

The Answer?

The analysis of potential credit exposure is not a substitute for traditional prudent risk management. A potential exposure model will not prevent the occurrence of the "next Enron" bankruptcy. What potential exposure can do is provide a consistent measurement framework that supports a number of vital credit risk management applications that greatly enhance a firm's ability to forecast, control, and respond to crisis events. The Enron horse is already out of the barn. But a potential exposure model will help close the barn door before the next crisis in the energy markets is upon us.

  1. "Companies' Enron exposure estimated at $6.3 bln" Reuters News Service, 7 December 2001
  2. Ibid.
  3. Ibid.
  4. As the Enron bankruptcy has not been completely resolved, all figures are preliminary
  5. NewPower Holdings Inc. was formed through a subsidiary and partnerships of Enron Corporation and is 44 percent owned by Enron.
  6. Ibid.
  7. Ibid.

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