FRM II-Counterparty

anbu.edu
Finance Junkie
Posts: 205
Joined: Mon Feb 04, 2013 3:35 pm

FRM II-Counterparty

Postby anbu.edu » Wed Nov 05, 2014 5:29 pm

For a portfolio of derivative contracts, Analyst Jane wants to estimate her firm's counterparty exposure on a future target date, T(1), which is one year forward. For convenience, she assumes the future value of the portfolio at that time, T(1) has a normal distribution with a mean of zero (an equal likelihood of a gain/ITM or loss/OTM on the position) and standard deviation of $3.0 million. Of course, Jane realizes this is an unrealistic assumption and that a Monte Carlo simulation is unlikely to produce a forward normal distribution! Nevertheless, consider the following two statements:
I. The Expected Exposure, EE[T(1)], is equal to zero
II. The Potential Future Exposure, PFE[T(1)], with 99.0% confidence, is almost $7.0 million
Which is (are) true?
a) Neither
b) I. is true
c) II is true
d) Both are true

The expected future value is equal to zero, but the expected exposure is an average of only the positive values (the gains); that is, expected exposure is a conditional average. Therefore, it must be higher than the expected future value; in this case, EE(T) = +$1.20 million.
The PFE(T) is similar to VaR (except it refers to gains, not losses, as gains create credit exposure!) such that PFE(T) = 2.33*$3.0 = $6.99 million.


I dont understand how they got 1.2 million

edupristine
Finance Junkie
Posts: 722
Joined: Wed Apr 09, 2014 6:28 am

FRM II-Counterparty

Postby edupristine » Thu Nov 06, 2014 12:17 pm

Hello anbu.edu,

Expected positive exposure = 0.27* Standard Deviation* [Square root(T)]

= 0.27* 2.33 * SQRT (365) = 1.201894 million


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