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FRM Part II · FRM Exam Part II · Credit Value Adjustment

A bank measures potential future exposure (PFE) for a netting set at the 95% confidence level for a six-month horizon and finds it to be 12m, while the expected exposure at the same date is 4m. Which interpretation of the 12m figure is correct?

The PFE of 12m means there is only a 5% chance that exposure at six months will exceed 12m. It is the 95th percentile of the exposure distribution, not an expected loss or an average; the average is the expected exposure of 4m.

  1. AThere is a 5% probability that the exposure at six months will exceed 12mCorrect
  2. BThe bank expects to lose 12m if the counterparty defaults
  3. CThe exposure at six months will average 12m across all scenarios
  4. DThe exposure will exceed 12m with 95% probability

Explanation

PFE at 95% is the 95th percentile of the exposure distribution at that date, so the exposure exceeds it in only 5% of scenarios. It is not an expected loss, since it ignores default probability and recovery. The average across scenarios is EE, given as 4m.

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