When a credit default occurs, the exposure at default is calculated using the positive exposure to the defaulting counterparty, appropriate recognition of netting where legally permitted. Prior to an actual default, the potential future exposure (PFE) can be derived using basic ‘MtM plus Add-On' style calculations or by using a sophisticated simulation engine. CVaR can also be estimated by integrating credit rating transition matrices into the calculation.
PFE measures are effective for quantifying future exposures and are the basic metrics used in trading credit limit systems. What they do not tell the risk manager, however, is the full cost of an actual default that has actually occurred in the market.
The reason is that the various positive and negative positions interact within trading portfolios, independent of counterparty, to generate factor sensitivities and resulting estimates of market risk. When a credit event occurs, these market risk numbers are instantaneously skewed as the defaulting counterparty's trades contributing to these measures are crystallized and removed from mark-to-market status. In this situation, nothing has happened in the actual market data and no trading has occurred.
Nevertheless, we now have potential breaches in market risk limits and we have potentially significant rebalancing to do before trading can continue on a normal basis. Furthermore, the necessary portfolio rebalancing often must be performed in an environment of market panic characterized by high levels of illiquidity driven by increased concern about the credit worthiness of remaining counterparties in the market.
The current environment demands that risk managers have tools to evaluate the market risk impact of a hypothetical default in advance.
In the immediate aftermath of a major default, such prior analysis allows a firm to focus on implementing corrective action rather than working out their position.
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