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FRM Part II · FRM Exam Part II · The Evolution of Stress Testing Counterparty Exposures

A risk manager at a bank reviews the exposure profile of a single uncollateralised, non-netted interest rate swap with a counterparty. Which description best defines the potential future exposure (PFE) of this trade at a given future date?

PFE is a high percentile, such as 97.5% or 99%, of the distribution of positive exposure at a future date. It captures a plausible worst-case exposure. The average of positive values is expected exposure, not PFE.

  1. AThe average of the positive mark-to-market values across all simulated scenarios at that date
  2. BA high percentile (for example 97.5% or 99%) of the distribution of positive exposure at that dateCorrect
  3. CThe loss expected on the trade after multiplying exposure by the default probability and loss given default
  4. DThe current replacement cost of the trade, floored at zero

Explanation

PFE is a high quantile of the exposure distribution at a future date, measuring a worst-case exposure at a chosen confidence level. The average of positive values is expected exposure (EE), which is the key distractor. Expected loss and current replacement cost are different concepts.

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