Counterparty Trading Limits Revisited: CSAs, IM, SwapAgent®, from PFE to PFL

Abstract

The utility of Potential Future Exposure (PFE) for counterparty trading limits is being challenged by new market developments, notably widespread regulatory Initial Margin (using 99% 10-day exposure), and netting of trade and collateral flows. However PFE has pre-existing challenges w.r.t. portfolios/distributions, collateralization, netting set seniority, and overlaps with CVA. We introduce Potential Future Loss (PFL) which combines expected shortfall (ES) and loss given default (LGD) as a replacement for PFE. With two additional variants Adjusted PFL (aPFL) and Protected Adjusted PFL (paPFL) these deal with both new and pre-existing challenges. We provide a theoretical background and numerical examples.

Keywords: PFE, exposure, CVA,initial margin, IM, SwapAgent, trading limits, capital

JEL Classification: K23, G11, G12, G13, G21, G24, E37, D81, D82, D52, D40, C15