What are counterparty exposure profiles, and how do Expected Exposure and Potential Future Exposure differ?
I'm studying counterparty credit risk for FRM Part II and struggling to distinguish between the various exposure metrics: Expected Exposure (EE), Expected Positive Exposure (EPE), and Potential Future Exposure (PFE). How are these profiles computed and why does each matter for different purposes?
Counterparty exposure profiles describe how the market value of a derivative position — and therefore the amount at risk if the counterparty defaults — evolves over time. Different metrics serve different purposes.
Key Exposure Metrics
- Mark-to-Market (MtM): The current value of the derivative. Can be positive (counterparty owes you) or negative (you owe the counterparty).
- Expected Exposure (EE) at time t: The average positive MtM at time t across all simulated scenarios: EE(t) = E[max(V(t), 0)]
- Expected Positive Exposure (EPE): The time-weighted average of EE(t) over the contract life: EPE = (1/T) * integral of EE(t) dt. This is used for Basel III CCR capital.
- Potential Future Exposure (PFE) at time t: The high quantile (typically 97.5% or 99%) of positive MtM at time t. This is the worst-case exposure used for credit limit management.
Example: Redstone Bank's Interest Rate Swap Portfolio
Redstone Bank has a 10-year receive-fixed interest rate swap with notional $500M against Whitfield Industries. Using Monte Carlo simulation of interest rate paths (1,000 scenarios), they generate the exposure profile:
| Year | EE ($M) | PFE 97.5% ($M) | MtM Mean ($M) |
|---|---|---|---|
| 1 | 8.2 | 28.5 | 2.1 |
| 3 | 15.7 | 52.3 | 5.4 |
| 5 | 18.4 | 61.8 | 3.2 |
| 7 | 14.1 | 48.6 | -1.8 |
| 10 | 0 | 0 | 0 |
Notice the hump-shaped profile: exposure starts low (not enough time for rates to move), peaks around year 5 (maximum rate uncertainty before amortization effects), and declines toward maturity (fewer remaining cash flows at risk).
Why Different Metrics for Different Purposes
- EPE for capital: Regulators want an average measure that reflects the full life of the trade, not just a single worst-case snapshot.
- PFE for limits: A risk manager setting a credit line for Whitfield Industries needs to know the maximum plausible exposure — not the average.
- EE for CVA: When pricing the credit valuation adjustment (the cost of counterparty default risk), you integrate EE(t) weighted by the counterparty's default probability at each time step.
FRM exam tip: Know the hump-shaped profile for interest rate swaps. Understand that EE < PFE at every time point, and EPE is a single summary number derived from the EE curve. Questions often present an exposure table and ask which metric is appropriate for a given use case.
For more counterparty risk content, explore our FRM Part II course.
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