A Conditional Valuation Approach for Path-Dependent Instruments
by Dante Lomibao of Bank of America, and
Introduction: In an effort to improve credit risk management, financial institutions have developed various measures to manage their exposure to counterparty risk. One important measure of counterparty risk is potential future exposure (PFE), which is a percentile (typically 95 or 99 percent) of the distribution of exposures at any particular future date. Credit exposure is the amount a bank can potentially lose in the event that one of its counterparties defaults. The measurement of exposure for derivative products is very important because it is used not only to set up trading limits but also as an essential input to economic and regulatory capital. The internal economic capital models used by most technologically advanced banks require the calculation of the distribution of the exposure at specified future times. For banks intending to use the internal model method in the new Basel II revised framework on trading activities, specific exposure measures such as the expected exposure (EE) and expected positive exposure (EPE)2 are required in the calculation of the regulatory capital.
This paper is republished as Ch.4 in...