Potential future exposure

Potential future exposure (PFE) is a measure of risk in relation to default by a counter-party to a financial transaction. It begins from the assumption that the transaction is proving beneficial to the party concerned and then calculates the potential loss should the counter-party default.

Where have you heard about potential future exposure?

You may have read last year that the Basel committee on bank regulation was looking at easing the rules on potential future exposure amid fears that the regulations can force banks to raise prices for customers or exit markets. The Bank of England supported this re-think.

PFE is an important measure in evaluating potential risks and, together with effective regulation, may have been able to identify the Black Swan trades that have been behind most major collapses of the past 30 years, including Enron, AIG and Lehman.

What you need to know about potential future exposure.

Potential future exposure is a measure of risk that has become of central importance to bank regulation since the financial crisis. It assesses the resilience of a bank's portfolio in relation to the danger of a counter-party defaulting on obligations such as a swap arrangement.

It is worked out by looking into the future, sometimes several years, and stating with a precise degree of confidence, perhaps 80 or 90 per cent, that at that point in the future, the bank will be looking at a gain, for example $5 million. Thus, the risk is that a default would cost the bank $5 million.