Introduction to Potential Future Exposure (PFE) and Credit Value-at-Risk (CVAR).(FINANCIAL ANALYSIS)(Column)

Credit risk measurement has evolved over time. Fewer companies are analyzing risk at a single point and are using techniques based on projecting risk factors over specific time periods. Included among the most popular of these techniques are Potential Future Exposure (PFE) and Credit Value-at-Risk (CVAR) using Monte Carlo simulations. Both methods enable assessment of default and/or credit migration (downgrades) probabilities.

Potential Future Exposure

Credit risk managers have traditionally remained focused on current exposure measurement (i.e., current mark-to-market exposure, plus outstanding receivables) and collateral management. The problem with this focus is that it places excessive emphasis on the present and fails to provide an acceptable indication of credit risk at some point in the future. Because losses from credit risk take a relatively long time to evolve, a more useful measure of exposure is potential exposure. Potential exposure is not like current exposure. It exists in the future and therefore represents a range or distribution of outcomes rather than a single point estimate.

Potential Future Exposure (PFE) is defined as the maximum credit exposures over a specified period of time calculated at some level of confidence. This maximum is not to be confused with the maximum credit exposure possible. Instead, the maximum credit exposure indicated by the PFE analysis is an upper bound on a confidence interval for future credit exposure.

The forward contract profile shown has a monotonically increasing PFE curve. The initial mark-to-market value of a forward contract is zero; hence there is no credit exposure. As time progresses, it is more likely that the forward contract will have either positive or negative mark-to-market value and, hence, the credit exposure. PFE for a forward contract reaches a maximum at the time of contract maturity as shown in the 13-month graph.

Having identified the potential credit future exposures and the level of credit quality of the given counter party, the trade finance and credit team can then develop a credit risk mitigation strategy and recommend different forms of solutions to the marketing team. You should still regard collateral rights as the primary means to provide credit support for those counter parties, which exceed the credit limit. You could also suggest the utilization of a Trade Finance Derivative, or silent bank guarantee. Other mitigation techniques to consider are as follows: netting agreements, cash collateral, margin calls and deposits, prepayments and early payments, parent company guarantees, letters of credit, credit insurance, surety bonds and termination clauses.

Credit Value-at-Risk