Expected Future Exposure

Formula:

Efe

 

This approach simulates market variables that influence the price of a derivative (ex: IR, FX) taking account the volatility of these market variables. 

For each scenario, the fair value of the derivative is calculated, which results in an exposure path over the life of the derivative.

Running this simulation many times and averaging the positive exposure and negative exposure results in EPE and ENE. 

 

Terms:

EPE = Expected Positive Exposure

dt = risk-free discount factor at time t

CVA utilises counterparty PDs, while DVA utilises own PDs. 

PD = probability of default

LGD = loss given default 

 

Collateral may be incorporated directly in the exposure simulation.

Netting may be applied when aggregating EPE/ENE over several derivatives with the same counterparty. 

Advantages:

- most theoretically pure approach

- methodology takes both current and potential future exposure into account 

- considers bilateral nature of derivatives 

- can be applied on transactional level or counterparty level 

- third-party software package available

 

Disadvantages:

- costly to implement

- involves complex modelling and requires advanced technical skills

- high requirements w.r.t IT infrastructure

 

 

 

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