What is 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.
Key takeaways
Potential future exposure (PFE) measures risk of counter-party default in financial transactions by calculating potential losses assuming the transaction is beneficial to the bank or party involved.
PFE has become central to bank regulation since the financial crisis, as it assesses portfolio resilience and may have identified Black Swan trades behind collapses like Enron, AIG, and Lehman.
The calculation projects future gains (sometimes years ahead) with a confidence level of 80-90 percent, where the risk equals the projected gain amount that would be lost if default occurs.
The Basel committee considered easing PFE rules due to concerns that regulations force banks to raise customer prices or exit markets, with Bank of England support for this reconsideration.
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.