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FRM Part II · FRM Exam Part II · Future Value and Exposure

A risk manager notes that a bank's counterparty exposure to a client is a single uncollateralized interest rate swap. Compared with the peak PFE used for limits, the regulatory capital exposure calculation based on effective EPE is typically lower for the same trade. What is the best reason?

Effective EPE is lower because it averages the non-decreasing expected exposure profile over time, whereas peak PFE takes a high quantile at the single worst date. Averaging means rather than tail percentiles produces a smaller number, so limits and capital measures differ.

  1. AEffective EPE averages the non-decreasing expected exposure over time rather than using a high quantile at the worst dateCorrect
  2. BEffective EPE ignores negative values of the counterparty's default probability
  3. CEffective EPE uses a 99.9th percentile of exposure at each date
  4. DEffective EPE applies only to collateralized trades

Explanation

Peak PFE is a tail quantile at the maximum date, while effective EPE is an average of expected (mean) exposures over the first year, so it is generally much smaller. It does not use a 99.9th percentile and applies to uncollateralized trades too.

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