Counterparty Trading Limits Revisited:CSAs, IM, SwapAgent(r), from PFE to PFL

TL;DR

This paper introduces Potential Future Loss (PFL) as a new metric to replace PFE for counterparty trading limits, addressing recent market and regulatory challenges with theoretical insights and numerical examples.

Contribution

It proposes PFL and its variants aPFL and paPFL, integrating ES and LGD to better handle portfolio complexities, collateralization, and netting issues.

Findings

PFL effectively addresses PFE's limitations in current markets.

Numerical examples demonstrate PFL's practical advantages.

Theoretical analysis supports PFL's robustness.

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.