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Chapter 8 Appendices

The document contains appendices that provide formulas for calculating exposure metrics like potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE) under the assumption of a normal distribution. The appendices show: 1) Formulas for PFE, EE, and EPE in terms of the normal distribution's mean and standard deviation. 2) An example exposure calculation for a forward contract using the normal distribution assumption. 3) An example exposure calculation for a swap that approximates the future value as normally distributed. 4) How to extend the approach to a cross-currency swap by combining the forward and swap approximations. 5) A simple netting calculation showing how netting

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Bindu Madhav
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145 views6 pages

Chapter 8 Appendices

The document contains appendices that provide formulas for calculating exposure metrics like potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE) under the assumption of a normal distribution. The appendices show: 1) Formulas for PFE, EE, and EPE in terms of the normal distribution's mean and standard deviation. 2) An example exposure calculation for a forward contract using the normal distribution assumption. 3) An example exposure calculation for a swap that approximates the future value as normally distributed. 4) How to extend the approach to a cross-currency swap by combining the forward and swap approximations. 5) A simple netting calculation showing how netting

Uploaded by

Bindu Madhav
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Online appendices from Counterparty Risk and Credit Value Adjustment a

continuing challenge for global financial markets by Jon Gregory


APPENDIX 8A: Formulas for EE, PFE and EPE for a normal distribution
Consider a normal distribution with mean (expected future value) and standard
deviation (of the future value) . Let us calculate analytically the two different
exposure metrics discussed. Under the normal distribution assumption, the future
value of the portfolio in question (for an arbitrary time horizon) is given by:
V Z ,

where Z is a standard normal variable.


i)

Potential future exposure (PFE)

This measure is exactly the same as that used for value-at-risk calculations. The PFE
at a given confidence level , ( PFE ) tells us an exposure that will be exceeded
with a probability of no more than 1 . For a normal distribution, it is defined by a
point a certain number of standard deviations away from the mean: PFE 1 ( ) ,

where 1 (.) represents the inverse of a cumulative normal distribution function (this
is the function NORMSINV(.) in Microsoft ExcelTM). For example, with a confidence
level of 99% , we have 1 (99%) 2.33 and the worse case exposure is 2.33
standard deviations above the expected future value.
ii)

Expected exposure (EE)

Exposure is given by:


E max(V ,0) max( Z ,0)

The EE defines the expected value over the positive future values and is therefore:

EE

( x) ( x)dx ( / ) ( / ) ,

where (.) represents a normal distribution function and (.) represents the
cumulative normal distribution function. We see that EE depends on both the mean
and the standard deviation; as the standard deviation increases so will the EE. In the
special case of 0 we have EE0 (0) / 2 0.40 .
iii)

Expected positive exposure

The above analysis is valid only for a single point in time. Suppose we are looking at
the whole profile of exposure defined by V (t ) t Z where now represents an

Online appendices from Counterparty Risk and Credit Value Adjustment a


continuing challenge for global financial markets by Jon Gregory
annual standard deviation (volatility). The EPE, integrating over time and dividing by
the time horizon, would be:

EPE

1
2

t dt / T
0

2
3 2

T 1 / 2 0.27T 1 / 2 .

Online appendices from Counterparty Risk and Credit Value Adjustment a


continuing challenge for global financial markets by Jon Gregory
APPENDIX 8B: Example exposure calculation for a forward contract.
Suppose we want to calculate the exposure on a forward contract and assume the
following model for the evolution of the future value of the contract (Vt ) : dVt dt dWt ,
where represents a drift and is a volatility of the exposure with dWt
representing a standard Brownian motion. Under such assumptions the future value at
a given time s in the future will follow a normal distribution with known mean and
standard deviation: -

Vs ~ N s, s

We therefore have analytical expression for the PFE and EE following from the
formulas in Appendix 8A.

PFE s s s 1 ( ) .

EE s s

s s
s.

Online appendices from Counterparty Risk and Credit Value Adjustment a


continuing challenge for global financial markets by Jon Gregory
APPENDIX 8C: Example exposure calculation for a swap.
Following the example in Appendix 8B, an approximation to a swap contract is to
assume that the future value at a given time s is normally distributed according to:

Vs ~ N 0, s (T s) ,
where the (T s ) factor corresponds to the approximate duration of the swap of
maturity T at time s. This assumes that the expected future value is zero at all future
dates which in practice is the case for a flat yield curve. We can show that the
maximum exposure is at s = T / 3 by differentiating the volatility term:

d
ds

s (T s)

1
2 s

(T s) s 0

Online appendices from Counterparty Risk and Credit Value Adjustment a


continuing challenge for global financial markets by Jon Gregory
APPENDIX 8D: Example exposure calculation for a cross-currency swap
Combined the results in the two previous Appendices, we consider a cross currency
swap to be a combination of the approximate FX forward and interest rate swap
positions.

The FX forward future value follows Vs ~ N 0, FX s and the interest rate swap

follows Vs ~ N 0, IR s (T s) . Assuming a correlation of between future value


of each, the approximate cross-currency swap future value will be given by:

2
V s ~ N 0, FX
s IR2 s (T s ) 2 2 FX IR s (T s ) ,

which is used to compute the PFE shown in Spreadsheet 8.4.

Online appendices from Counterparty Risk and Credit Value Adjustment a


continuing challenge for global financial markets by Jon Gregory
APPENDIX 8E: Simple netting calculation
We have already shown in Appendix 8A that the EE of a normally distributed random
variable is:
EEi i ( i / i ) i ( i / i ) .
Consider a series of independent normal variables representing transactions within a
netting set (NS). They will have a mean and standard deviation given by:
n

2
NS
i2 2 ij i j

NS i
i 1

i 1

i 1
j i

where ij is the correlation between the future values. Assuming normal variables
with zero mean and equal standard deviations, , we have that the overall mean and
standard deviation are given by:

n n ( n 1)

2
NS

NS 0

where is an average correlation value. Hence, since (0) 1 / 2 , the overall EE


will be:

EE NS n n(n 1) / 2
The sum of the individual EEs gives the result in the case of no netting (NN):

EE NN n / 2
Hence the netting benefit will be:

EE NS / EE NN

n n(n 1)
n

In the case of perfect positive correlation, 100% , we have:

EE NS / EE NN

n n(n 1)
100%
n

The maximum negative correlation is bounded by 1 /( n 1) and we therefore


obtain:

EE NS / EE NN

n n(n 1) /(n 1)
0%
n

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