PART 3 – PFE CALCULATIONS

In the first two parts of this series (parts one and two can be found here), we introduced the approach for measuring a bank’s Exposure at Default and its two components, the replacement cost and the potential future exposure (PFE). We also outlined the benefits of the SA-CCR approach in recognizing the risk-reducing effect of netting and hedging sets and explored the methodology. In this final part of the series, we look at PFE calculations.

In our previous article, we established that the computation of the PFE add-on component is the most complex as it varies widely depending on several attributes:

  • Asset class and subclass;
  • Collateralization;
  • Margin set, and;
  • Netting set considered.

Naturally, this brings out various computational challenges that we will explore in more detail in this article.

While there are several other challenges to remain compliant when implementing SA-CCR, the coordination and alignment by various departments within the financial institution are often the most difficult to overcome. Achieving compliance requires banks to ensure the completeness and accuracy of the SA-CCR trade population from various front-office systems, market data, legal and collateral data from numerous intermediaries, and risk services.

To keep this article concise, we are using just one asset class – Equity Derivatives – as the example, but PFE calculations apply similarly to all other asset classes.

Here’s a review of some of the practical issues and problems within the Equity Derivatives SA-CCR add-on calculations to illustrate various intricacies and challenges.

Adjusted Notional

The adjusted notional (CRE 52.30) is a measure of the size of the trade. For Equity Derivatives, it is simply the current price of the relevant share multiplied by the number of shares/units that the derivative references. Therefore, complete and accurate trade and market data would be required with correct scaling factors from various front-office systems with the latest market spot prices. Also, some trades are fixed notional contracts, for which a new SA-CCR adjusted notional would have to be computed.

Supervisory Delta

The supervisory delta (CRE 52.40) is used to determine the trade direction and whether the trade has a non-linear relationship (e.g., options) with the underlying risk factor. The prescribed formula requires the following information:

  • Buy/sell flag,
  • Call/put flag,
  • Forward or spot price,
  • Option strike price,
  • Contractual exercise date, and
  • Supervisory volatility parameter, which depends on whether the underlying is single stock or an equity index.

Again, complete and accurate trade and market data would be required to calculate the PFE accurately.  This data may be trivial for simple vanilla equity or index options but becomes much more complicated for the structured or exotic equity derivative products.

Exotics

Several considerations, system requirements, and in most cases, a total redesign would be required to deal with the treatment of exotic equity derivatives products. This is due to a variety of issues, including:

  • Basket / multi-underlying options
  • Packages consisting of multiple options
  • Missing or unavailable call or put flags
  • Inconsistent spot and strike metric unit
    • Some strike prices are set in percentage terms instead of absolute value hence mismatch with spot value.

The main benefit of SA-CCR comes from the offsetting nature of the underlying equities. However, if the granular data is not available, this benefit is not only missed but could also lead to overstatement.

Given the data challenges outlined above, the approach would then have to rely on a default mechanism for Supervisory Delta treatment, which typically tends to be punitive or highly conservative, with no netting benefit. Missing or unavailable underlying asset information means you cannot determine whether it is an index or single stock, and therefore it must default to the highest supervisory parameters (supervisory factor and supervisory option volatility). A process for exceptions, exclusions, and default treatment review and reconciliation would need to put in place, with appropriate controls, governance, and monitoring.

The challenges of calculating SA-CCR are significant and can significantly impact financial institutions. The correct computation is critical to avoid overstatement leading to the increased capital requirements or understatement, which could lead to punitive measures by the regulators!


Written by: Safder Dhirani, Regulatory Consultant