Potential Future Exposure is actually derived from mark-to-market and revaluing the portfolio and considered an estimate of MTM, but at a specific point in the future. Similar to Value at Risk, PFE is also based on a high confidence level, taking into account the worst-case scenario. The current MtM may follow a number of different possible paths into the future, so a probability distribution of PFE can be derived.
Example of Potential Future Exposure?
For example, an organization may calculate its potential future exposure as USD 10mn at a confidence interval of 99% for the next year. It means that “In the next year, we are 99% confident that our gain in the swap will be $10 million or less.
To add to the example, the calculation of Potential Future Exposure (PFE) is an important risk management tool for organizations that engage in derivative transactions. By estimating PFE, organizations can better understand and manage their risk exposure, which can help to prevent large losses in the future.
For instance, a bank may use PFE to calculate its exposure to credit risk in its portfolio of derivatives. By estimating the potential future losses for a given time horizon, the bank can determine the amount of collateral it needs to hold to cover its potential losses. This helps to ensure that the bank has sufficient liquidity to meet its obligations in case of adverse market movements.
Moreover, PFE can also help organizations to assess the impact of new transactions on their risk exposure. By estimating the PFE of a proposed transaction, organizations can evaluate whether the potential benefits outweigh the potential risks. This can help them to make more informed decisions about whether to enter into a particular transaction.
Overall, PFE is an important risk management tool that allows organizations to estimate their potential future losses for a given time horizon. It helps organizations to better understand and manage their risk exposure and make more informed decisions about their derivative transactions.