What percentile defines potential future exposure and how is it used for limits?

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AcadiFi · Accepted Answer

Potential future exposure (PFE) is a high percentile of the future exposure distribution, typically 95% or 97.5%, though some institutions use 99% for regulatory stress or extreme-risk applications. The choice depends on risk appetite, counterparty tier, and regulatory requirement. Basel's IMM framework uses effective EPE (mean-based) for capital but banks commonly use 97.5% PFE for internal limits. For a 7-year cross-currency swap with Nordhaven Commodities on $350M notional, the 95% PFE might be $28M at peak while the 97.5% PFE is $34M and the 99% PFE is $42M — tail thickness matters. Practical limit setting. Set PFE limits at the netting set level, not individual trade level, because netting and collateral dramatically reduce net exposure. Tier counterparties: prime banks might get $500M PFE limits, mid-tier corporates $50M, hedge funds $25M with tighter monitoring. Monitor peak PFE over the trade life and cumulative PFE over specified horizons (1y, 5y). Incorporate wrong-way risk: if PFE rises as counterparty credit deteriorates, effective PFE for limit purposes should be stressed. Limit breaches trigger collateral calls, trade restructuring, or unwinds. The 97.5% level aligns with regulatory stress tests (Basel, FRTB-CVA) and is a common industry practice, but there's no universal right answer — document your choice in policy and stick to it.

What percentile defines potential future exposure and how is it used for limits?

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