Linear, yet attractive, Contour

Banks’ Potential Future Exposure models are at the core of the advanced EAD (Exposure At Default) approach to capital requirements for credit risk considered in the New Basel Capital Accord. Juan Cárdenas, Emmanuel Fruchard and Jean-François Picron look at a method to quickly and accurately estimate Potential Future Exposure on portfolios of OTC derivatives dealt with a single counterparty with whom netting applies.

In the early 1990s credit officers started evaluating the Potential Future Exposure (PFE) of OTC derivative trades. The calculation was relatively easy as long as it was done on a trade-by-trade basis. The exposure, for instance, on a Japanese bank was equal to the sum of the trades’ expected exposures. The notion of add-on emerged as statistical averages of such calculations.

However netting progressively applied in most countries where this trading takes place, and the complexity of the