Riskand CVAExotic Derivatives

Risk and CVA for exotic derivatives: the universal
modeling
Alexandre Antonov, Serguei Issakov and Serguei Mechkov
Numerix
Quant Congress USA, New-York
July 2011
A. Antonov, S. Issakov and S. Mechkov; Numerix Risk and CVA for exotic derivatives: the universal modeling 1/ 51
Outline
Exposure: Scenarios vs. Modeling
Future price and exposure for callable instruments in the
Modeling Framework
Backwards pricing using the Least Squares MC
Aggregation of exercises into the instrument exposure
Direct approach: cumbersome tracking of exercise indicators
New approach: automatic recursion
CVA
Risk: measure dependence and the real-world measure as
ctitious currency
Examples and conclusion
The main subject calculation of exotic portfolio exposure
What is exposure at time t?
Possible values of the portfolio price at t (possibilities are related

with dierent scenarios of the market evolution)
Two approaches:
Scenarios
Modeling
Selected books, reviews and articles of the subject:
Canabarro and Due (2003), Pykhtin (2005), Cesari et al (2010),
Jon Gregory (2010), Brigo-Capponi (2010), Pykhtin-Rosen (2010)
Brigo-Capponi-Pallavicini-Papatheodorou (2011)
Scenario based approach
Algorithm
Generate a set of markets (scenarios) M

i
(t) at time t (yield
curves, implied vols etc.)
For each market choose a model and calibrate it to the market
Price the portfolio with the calibrated model for each market
Drawbacks
Not clear how to generate scenarios
The period from today to the observation time t not taken

into account
Computationally (very) intensive

Modeling approach
Arbitrage-free model properly calibrated to today implied market
the best scenario generator
Full time coverage: scenarios for all the time-steps
Exposure is automatically consistent with the pricing
Adaptation to indexes projections by the model measure

change
Numerical eciency
Key idea
associate portfolio exposure with its future price given by an
arbitrage-free model (Cesari et al)
Two types of instruments in the exposure calculation:
For vanillas which price is dened uniquely by the market

one can use the scenario approach
For exotic instruments

one needs the modeling approach
Below we will consider a portfolio of exotic instruments and will
apply the modeling approach (a.k.a. one-step MC).
Measures
The model calibrated to today market still has an extra degree of
freedom the model measure.
Its properties:
Instrument PV does not depend on the measure
Distribution of underlying depends on the measure

We address a real world measure at the end. Now consider our
model evolution under any xed measure.
A Risk (VaR etc) is related to the distributions

measure dependent
A credit value adjustment (CVA) is linked with PVs of

default dependent payments
measure independent
Modeling approach: swap example
Consider a swap paying an index
j
at a payment date
j
for
j = 1, , M.
The instrument price PV (discounted expectation) of the
payments
S(0) = E
_
_
M
j =1
j
N(
j
)
_
_
where N(t) is the model numeraire and E[ ] is the pricing
expectation in the model measure.
The swap future price S
F
(t) for some observation date t = t
obs
is
a conditional expectation
S
F
(t) = N(t) E
_
_
M
j =1
j
N(
j
)
F
t
_
_
The swap future price S
F
(t) consists of two parts
S
F
(t) =
M
j =1,
j
<t
j
N(t)
N(
j
)
+ N(t) E
_
_
M
j =1,
j
t
j
N(
j
)
F
t
_
_
Payments before t are discounted forward to t

j
N(t)
N(
j
)
Payments after t are replaced by discounted expectations

N(t) E
_

j
N(
j
)
F
t
_
Conditional expectation and numerical methods
Conditional expectation (CE) E[ | F
t
] averaging over the
stochastic evolution after time t (the life before or on t is xed).
Example. For diusion processes we x the Brownian increments
dW() for t and average over dW() for > t; the CE is
thus a certain function of dW() for t.
For regular path-independent pay-os P(T) xed at time T, a
(discounted) CE is a function of model states x
i
(t)
E
_
N(t)
P(T)
N(T)
| F
t
_
= f (t; x
i
(t))
The CE depends on the Brownian increments through the states.
For example, the model states can be short rates and FX-rate
CE of an index xed at before the time t coincides with the
index itself nothing to average
N(t) E
_
P()
N()
F
t
_
= N(t)
P()
N()
Below we consider MC simulations with a possibility of CE
calculation typical numerical method of CE calculation is a
regression to state variables,
E
_
N(t)
P(T)
N(T)
| F
t
_

j

j
(x
1
(t), x
2
(t), )
where
j
are regression coecients and
j
(x
1
(t), x
2
(t), ) are
basis functions (their choice is the method key).
Other known names of the method: Longsta-Schwartz, Least
Squares MC, American MC (see Andersen-Piterbarg (2010) for
review)
Modeling approach: Bermudan swaption example
Consider a Bermudan swaption giving a right to enter into the
swap dened above on exercise dates T
i
.
The swaption PV discounted non-conditional expectation of the
payments subjected to the exercise conditions
V(0) = E
_
_
M
j =1
I(
j
)

j
N(
j
)
_
_
where indicator I(
j
) equals to one if we have entered into the
swap before the payment date
j
and zero otherwise.
The swaption future price for some observation date t = t
obs

discounted conditional expectation
V
F
(t) = N(t) E
_
_
M
j =1
I(
j
)

j
N(
j
)
F
t
_
_
Future price decomposition
The obvious property of the discounted future price
V(0) = E
_
V
F
(t)
N(t)
_
The future price observed at t
obs
V
F
(t
obs
) = V(t
obs
) (1 I(t
obs
)) + V
e
(t
obs
) I(t
obs
)
can be split in two parts:
continuation value V(t

obs
) (the option was not exercised till
t
obs
)
exercise value V
e
(t
obs
) (the option was exercised before t
obs
)
Continuation value
It can be shown that the continuation value satises recursive
relation on exercise dates
V(T
j
) = max
_
N
T
j
E
_
V(T
j +1
)
N(T
j +1
)
| F
T
j
_
, S(T
j
)
_
where S(t) is the swap as seen at time t with payments after t.
S(t) =
j ,
j
t
N(t)E
_

j
N(
j
)
F
t
_
The continuation value coincide with option underlying calculated
by a backwards induction. Note that the total option future value
contains also exercise part.
Introduce the instrument days T = {
1
,
2
, }
{T
1
, T
2
, },
a union of exercise dates T
j
and payment dates
k
.
Backward induction:
Update underlyings on the instrument dates (in pseudo-code

notations)
max(V(T
j
), S(T
j
)) V(T
j
) on exercise dates T
j
S(
k
) +
k
S(
k
) on payment dates
k
Calculate discounted conditional expectation between the

instrument dates
V(t) = N(t)E
_
V(T)
N(T)
F
t
_
, S(t) = N(t)E
_
S(T)
N(T)
F
t
_
for t, T T .
Typical numerical method regression
Indicators
The indicator I(t) participating in the future price formula can be
constructed from conditional exercise indicators
C
j
= 1
S(T
j
)>V(T
j
)
which equals to 1 if we exercise at T
j
provided that we did not
exercise before and 0 otherwise
I(t) = I
j
for T
j
t < T
j +1
where
I
j
= 1
j
i =1
(1 C
i
)
Exercise value
The exercise value consists of the payments after the observation
date (swap S(t
obs
)) and payments before the observation date
V
e
(t
obs
) = S(t
obs
)I(t
obs
) + N
t
obs
j ,
j
<t
obs
I(
j
)

j
N(
j
)
Remark. The second part of the exercise value is sum for forward
discounted payments occurred before the observation date.
Instrument exposure
The exposure O(t
obs
) is closely related with the option future
price. There are two choices available:
Exposure includes all payments (coincides with the future

price)
O(t
obs
) = V
F
(t
obs
) = V(t
obs
) (1 I(t
obs
)) + V
e
(t
obs
) I(t
obs
)
Exposure only includes the future payments with respect to

the observation date
O(t
obs
) = V(t
obs
) (1 I(t
obs
)) + S(t
obs
) I(t
obs
)
Exposure path-dependence
Exposure is a path-dependent product (for callable deals). For
example, the continuation part V(t
obs
) (1 I(t
obs
)) consists of
two contributions
Continuation value V(t

obs
) is a state Underlying i.e. a certain
function of the model states on the observation date
The indicator I(t

obs
) is path-dependent (a combination of
Underlyings for exercise dates before the observation)
The exposure calculation
Two approaches for the exposure calculation
Direct
Calculate all components in the backwards pricing procedure
and assemble them in the forward pass
Automatic
Change Underlying operations to obtain the exposure as
by-product of the pricing procedure
Remark. A good quality backward induction algorithm is essential.
Direct approach: algorithm
Backward induction
Calculate and store the underlying swap, the option
continuation value and conditional exercise indicators by
backward induction using the least-square MC
Forward induction
Calculate unconditional exercises and roll forward index
payments to the observation date
Results aggregation
A similar procedure was proposed in Cesari et al. Modulo some
dierence (for example, the exercise time instead of the exercise
indicators) it is equivalent to ours.
Drawbacks of the direct exposure calculations
1. Requires modication of backward pricing procedure
2. Includes both backward and forward inductions
3. Includes the cumbersome logic of exercise indicators
calculation and aggregation
4. Can be very complicated for exotic instruments with dierent
types of exercises
Alternative automatic procedure
Automatic exposure calculation
Recall that the backward pricing reduces to recursive iterations
the update of underlyings
max(V(T
j
), S(T
j
)) V(T
j
), S(
k
) +
k
S(
k
)
the discounted conditional expectation
V(t) = N(t)E
_
V(T)
N(T)
F
t
_
, S(t) = N(t)E
_
S(T)
N(T)
F
t
_
For the conditional exercise indicator C
j
= 1
S(T
j
)>V(T
j
)
we can
rewrite the option update as follows
V(T
j
) (1 C
j
) + S(T
j
) C
j
V(T
j
)
Introduce exposure underlyings with the hat symbol for our
products in hand: swaption exposure underlying

V and swap

S.
In parallel with the main pricing procedure execute the following:
For dates after or on the observation date

the exposure underlyings coincide with the pricing ones
V(t) = V(t) and

S(t) = S(t) for t t
obs
For dates before the observation date proceed as below

For dates before the observation date t < t
obs
modify the update
and conditioning procedures
The same update rules for the swaption
V(T
j
) (1 C
j
) +

S(T
j
) C
j

V(T
j
)
Modied update rules for the swap
all payments in the exposure
S(
k
) +
k

S(
k
)
future payments in the exposure
S(
k
)

S(
k
)
No conditional expectation (regression) before the observation

date (t < t
obs
)
V(t) = N(t)
V(T)
N(T)
,

S(t) = N(t)
S(T)
N(T)
Exposure O(t
obs
) =

V(0) N(t
obs
)
Why so?
Compare the option price
V(0) = E
_
_
M
j =1
I(
j
)

j
N(
j
)
_
_
with its exposure underlying
V(0) = E
_
_
M
j =1
I(
j
)

j
N(
j
)
F
t
obs
_
_
The only dierence is the conditional expectation in the future
price that is why we have stopped the regression in the
exposure calculation before the observation date.
Recursion example
Future payments in the exposure no swap update on the
payment dates before the observation date
The swaption update on the exercise dates
V(T
j
) (1 C
j
) +

S(T
j
) C
j

V(T
j
)
The discounting between the exercise dates (no events on the
payment dates)
V(T
j 1
) = N(T
j 1
)
V(T
j
)
N(T
j
)
,

S(T
j 1
) = N(T
j 1
)
S(T
j
)
N(T
j
)
It can be shown that the recursion
V(T
j 1
)
N(T
j 1
)
=
V(T
j
)
N(T
j
)
(1 C
j
) +
S(t
obs
)
N(t
obs
)
C
j
leads to the desired
O(t
obs
) =

V(0) N(t
obs
) = V(t
obs
) (1 I(t
obs
)) + S(t
obs
) I(t
obs
)
Alternative algorithm
For dates before the observation date t < t
obs
modify the update
and conditioning procedures
The same update rules for the swaption
V(T
j
) (1 C
j
) +

S(T
j
) C
j

V(T
j
)
Modied update rules for the swap
all payments in the exposure:
S(
k
) +
k
N(t
obs
)
N(
k
)

S(
k
)
future payments in the exposure
S(
k
)

S(
k
)
No conditional expectation (regression) and discounting after

the observation
Exposure O(t
obs
) =

V(0)
Similar recursion logic was applied in Eglo et al (2007) and
Andersen-Piterbarg (2010) Sect 18.3.4. in a context of pricing of
Callable Libor Exotics.
Our contribution:
We target explicitly the future price (exposure)
We generalize it for arbitrarily complex instrument

Generalization.
Imagine our (complicated) instrument containing multiple
underlyings U
m
(T) (legs, swaps, options etc. having currency
dimensions) and possibly multiple exercise conditions.
To calculate exposures O
m
(t
obs
) for all underlings dene
corresponding exposure underlyings

U
m
(T). They are identical to
the underlyings for t > t
obs
U
m
(t) = U
m
(t) for t > t
obs
and obey the following update rules for t < t
obs
.
Linear update rules of the underlyings lead to the same

relation with the exposure underlyings
m,k
U
m
(T) U
k
(T)
m,k

U
m
(T)

U
k
(T)
where
m,k
are dimensionless values (for example, numbers or
barrier exercise indicators)
Non-linear update rules of the underlyings (optimal exercise)

max(U
m
(T), U
n
(T)) U
k
(T)
U
m
(T) (U
m
(T)U
n
(T))+
U
n
(T) (U
n
(T)U
m
(T))

U
k
(T)
where (x) = 1 for positive x and zero otherwise
Update rules for pure payments

n,k
having currency
dimensions
U
n
(
k
) +
n,k
U
n
(
k
)
lead to the following updates on the level of the exposure
underlyings
all payments in the exposure
U
n
(
k
) +
n,k

U
n
(
k
)
future payments only in the exposure
U
n
(
k
)

U
n
(
k
)
No conditional expectation (regression) before the observation

date (t < t
obs
)
U
n
(t) = N(t)
U
n
(T)
N(T)
Exposures O
m
(t
obs
) =

U
m
(0) N(t
obs
)
CVA
Consider now the Credit Value Adjustment (CVA) calculation
1
, see
also Cesari et al.
Assume that the Counterparty survival process (t)

a Poisson process with stochastic intensity (hazard rate)
h(t) and independent jumps
Extend our initial pricing model with (possibly correlated)

hazard rate process calibrated to the corresponding credit
market simulate all the components
Calculate the portfolio future values for a ne set of dates

(t) using the algorithm above (do not include the credit
hazard rates into the regression variables)
Assume also that we have calculated the collateral, C(t),

which consists of a certain number (t) of units of some
asset A(t) with known (simulated) evolution,
C(t) = (t) A(t).
1
Our portfolio does not have an explicit default risk.
The Self (our) exposure at time t is
O(t) = ((t) C(t))
+
CVA = (1 RR
C
)
_
T
0
E
_
d(t)
O(t)
N(t)
_
where RR
C
is the Counterparty recovery rate which is assumed to
be constant.
Explanation. If the Counterparty defaults (d(t) = 1) on the
interval [t, t + dt], our loss will be equal to ((t) C(t))
+
, and
this innitesimal payment, as seen at the origin, is equal to the
discounted expectation.
Averaging over jumps (independent from the hazard rate)
CVA = (1 RR
C
)
_
T
0
E
_
dH(t)
O(t)
N(t)
_
= (1 RR
C
)
_
T
0
E
_
dt h(t) H(t)
O(t)
N(t)
_
eective replacement of the survival processes by the hazard
discount factor
H(t) = e
_
t
0
d h()
Our extended model, equipped with the Least Squares MC, is able
to compute the above averages
The future portfolio value is calculated as above (the credit

hazard rates are not included into the regression variables)
The collateral and the hazard discount factor are simulated
The integral element is estimated by averaging

Remark. DVA and Bilateral CVA can be computed in a similar way.
Risk
The risk measure is a general term for statistical characteristics of
the instrument exposure non-discounting (simple) averages
E[f (O(t))]
A simple average is measure-dependent (contrary to the discounted
one E[f (O(t))/N(t)])
Examples.
Potential Future Exposure (PFE) for a condence level

q
(t) = inf{x : E[1

O(t)<x
] }
Expected Shortfall or Expected Tail Loss

E[O(t) | O(t) > q
(t)]
Expected Positive Exposure (EPE)

E[O(t)
+
]
Right/wrong way exposure
When the model evolution is highly correlated with the default
process the exposure distribution conditional to the default is
important, i.e. instead of the CDF of the exposure
CDF(t, x) = E[1
O(t)<x
]
we need a conditional CDF to default happening at time t
CDF
D
(t, x) = E[1
O(t)<x
| = t]
where is a stochastic default time.
Following our CVA considerations we have
CDF
D
(t, x) =
E[1
O(t)<x
d(t)]
E[d(t)]
=
E[1
O(t)<x
h(t) H(t)]
E[h(t) H(t)]
where h(t) is the stochastic hazard rate and H(t) = e
_
t
0
d h()
is
the hazard discount factor
Real world measure
A model calibrated to todays market still has an extra degree of
freedom the model probability measure.
We want to x this measure to be the real-world one for the
exposure distribution.
The real-world (or physical) probability measure appeared early in
Quantitative Finance has not been widely used due to its loose
denition, contrary to the risk-neutral measure.
The risk-neutral approach assumes that tradable securities have
drift coinciding with the short rate r (t) a zero-bond SDE
dP(t, T) = P(t, T) (r (t) dt + (t) dW(t))
In the real world, this drift is supposed to be dierent but its
time-series estimations are vague.
We need to link our model to the real-world in a more rigorous way
by requiring that some non-discounting (simple) averages hold.
Fixing projections
Suppose that we have a set of indices I
j
xed at some times t
j
and
their projections in the future p
j
p
j
= E
RW
[I
j
]
as expectation in the real-world (RW) measure. Our initial
arbitrage-free model in its risk-neutral measure cannot return a
priori such averages
p
j
= E[I
j
]
So we should modify the model measure in order to meet the
projections.
Remark. Note that the model is calibrated to the implied market
(initial rates, implied vols, etc.) and the only freedom to reproduce
the projection is in the measure choice.
Cross-currency analogy
Set our initial model as foreign one w.r.t. some FX-rate process
and a domestic currency model.
Our initial model states will get a drift adjustment depending
on FX vol and correlations.
Result. The initial model in such cross-currency (CC) setup will
have a dierent measure w.r.t. to its risk-neutral one.
Realization.
Domestic model (factitious ccy RW)

Trivial model with zero rates unit numeraire: N
RW
(t) = 1
FX-rate model (between the initial ccy and the factitious one)
Black-Scholes model
Foreign model (initial ccy)

Out initial model
Remark. The FX volatility permits to step up from the risk neutral
measure towards the RW one.
The CC model calibration:
The foreign component (initial model) is calibrated to its

implied market
The FX-vol and correlations are free they are tools to

calibrate the indexes projections
The resulting CC model capabilities:
Pricing of the initial instrument (identical to the initial pricing

up to numerical errors)
Exposure simulation in the real-world measure

Remark. The BS process for the FX-rate makes a deterministic
drift change for the foreign (initial) model. More complicated
FX-rates evolution, say Heston, gives richer family of the measure
change more degrees of freedom for the calibration to real-world
projections.
Numerical experiments
Instrument (cancelable swap)
swap
we receive semi-annually a 6M Libor and pay annually a xed
rate (= 2.57%, a swap rate at origin) on 1 EUR notional
exercise
we have a right to cancel the swap annually from 4Y
Output
6M Libors expectation in dierent measures
distribution (CDF) of 6Y instrument exposure (including the

future payments only) in dierent measures
exposure prole in the risk-neutral measure
PFE 97.5% in dierent measures

Model
CC Model
Domestic model (RW currency)

Trivial model with zero interest rates
Foreign model (EUR)

Hull-White IR model with 3% rate, 5% mean-reversion and
1.5% volatility
FX rate (RW currency/EUR)

BS model with correlation with HW Brownian motion
= 100% and a set of FX-volatilities: 0%, 25%, 50%
Dierent FX-volatilities correspond to dierent measures.
Zero FX-volatility gives the risk-neutral measure.
For simplicity we consider the Counterparty default uncorrelated
with the CC model factors.
0
0.02
0.04
0.06
0.08
0.1
0.12
0 2 4 6 8 10 12
L
i
b
o
r
a
v
e
r
a
g
e
,
%
date,years
fxvol0%
fxvol25%
fxvol50%
Figure: 6M Libor averages for dierent FX-vols (dierent measures).
0
0.2
0.4
0.6
0.8
1
0.1 0 0.1 0.2 0.3 0.4 0.5
C
D
F
ExposureValue
fxvol0%
fxvol25%
fxvol50%
Figure: CDF of 6Y exposure for dierent FX-vols (dierent measures).
0.15
0.1
0.05
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0 2 4 6 8 10 12
v
a
l
u
e
,
E
U
R
date,years
PFE2.5%
EPE
PFE97.5%
Figure: Risk prole in the risk-neutral measure.
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0 2 4 6 8 10 12
v
a
l
u
e
,
E
U
R
date,years
fxvol0%
fxvol25%
fxvol50%
Figure: PFE 97.5% for dierent FX-vols (dierent measures).
Observations
Typical shape of the risk prole
Measure change leads to a positive drift in rates: the bigger

FX-vol, the bigger Libor average
Signicant dierences is the exposure distributions in dierent

measures
It is important to use the pricing model in the real-world measure
(the factitious CC model should be calibrated to the rates
projections) to get the correct exposure distribution.
Conclusion
We presented:
Calculation of the portfolio exposure in a self-consistent way

using arbitrage-free model calibrated to both implied market
and real-world projections
A new automatic method of exposure calculations especially

attractive for exotic portfolios avoiding cumbersome exercise
aggregation
Ecient CVA calculation using the simulated information

Lief Andersen and Vladimir Piterbarg (2010) Interest Rate
Modeling, Atlantic Financial Press
Damiano Brigo and Agostino Capponi, (2010) Bilateral
counterparty risk with application to CDSs, Risk Magazine,
March 2010
Damiano Brigo, Agostino Capponi, Andrea Pallavicini, and
Vasileios Papatheodorou (2011), Collateral Margining in
Arbitrage-Free Counterparty Valuation Adjustment including
Re-Hypotecation and Netting, Available at SSRN
Eduardo Canabarro and Darrell Due (2003) Measuring and
Marking Counterparty Risk, DefaultRisk
Giovanni Cesari, John Aquilina, Niels Charpillon, Zlatko
Filipovic, Gordon Lee, Ion Manda (2010) Modelling, Pricing,
and Hedging Counterparty Credit Exposure: A Technical
Guide, Springer Finance, Berlin
Daniel Eglo, Michael Kohler, and Nebojsa Todorovic (2007)
A dynamic look-ahead Monte Carlo algorithm for pricing
Bermudan options, Ann. Appl. Probab. Volume 17, Number
4, 1138-1171
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challenge for global nancial markets, Wiley Finance
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Risk at the Trade Level and CVA Allocations, Journal of
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Contact information
www.numerix.com
UK Numerix Software Ltd, 2nd oor 41 Eastcheap London EC3
Tel +44 (0) 207 648 6100, Fax +44 (0) 207 648 6139
antonov@numerix.com

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Risk and CVA for exotic derivatives: the universal

Possible values of the portfolio price at t (possibilities are related

Generate a set of markets (scenarios) M

For each market choose a model and calibrate it to the market

Not clear how to generate scenarios

The period from today to the observation time t not taken

Computationally (very) intensive

Full time coverage: scenarios for all the time-steps

Exposure is automatically consistent with the pricing

Adaptation to indexes projections by the model measure

For vanillas which price is dened uniquely by the market

For exotic instruments

Instrument PV does not depend on the measure

Distribution of underlying depends on the measure

A Risk (VaR etc) is related to the distributions

A credit value adjustment (CVA) is linked with PVs of

Payments before t are discounted forward to t

Payments after t are replaced by discounted expectations

continuation value V(t

Update underlyings on the instrument dates (in pseudo-code

Calculate discounted conditional expectation between the

Exposure includes all payments (coincides with the future

Exposure only includes the future payments with respect to

Continuation value V(t

The indicator I(t

For dates after or on the observation date

V(t) = V(t) and

For dates before the observation date proceed as below

The same update rules for the swaption

Modied update rules for the swap

all payments in the exposure

future payments in the exposure

No conditional expectation (regression) before the observation

The same update rules for the swaption

Modied update rules for the swap

all payments in the exposure:

future payments in the exposure

No conditional expectation (regression) and discounting after

We target explicitly the future price (exposure)

We generalize it for arbitrarily complex instrument

Linear update rules of the underlyings lead to the same

Non-linear update rules of the underlyings (optimal exercise)

Update rules for pure payments

all payments in the exposure

future payments only in the exposure

No conditional expectation (regression) before the observation

Assume that the Counterparty survival process (t)

Extend our initial pricing model with (possibly correlated)

Calculate the portfolio future values for a ne set of dates

Assume also that we have calculated the collateral, C(t),

The future portfolio value is calculated as above (the credit

The collateral and the hazard discount factor are simulated

The integral element is estimated by averaging

Potential Future Exposure (PFE) for a condence level

(t) = inf{x : E[1

Expected Shortfall or Expected Tail Loss

Expected Positive Exposure (EPE)

Domestic model (factitious ccy RW)

Foreign model (initial ccy)

The foreign component (initial model) is calibrated to its

The FX-vol and correlations are free they are tools to

Pricing of the initial instrument (identical to the initial pricing

Exposure simulation in the real-world measure