A swap entered at zero market value can create a large unsecured claim six months later. The desk therefore needs a distribution of future replacement costs, not just today's price or the trade's notional. This lesson turns risk-neutral valuations into positive and negative exposure profiles, explains what a percentile adds to a mean, and prepares the inputs for CVA and DVA.
Learning objectives. By the end of this note you should be able to:
- convert signed replacement values into each party's exposure;
- calculate expected exposure and potential future exposure from scenarios;
- distinguish a time profile from the distribution of a path maximum;
- explain why a pricing exposure and a risk-management exposure can differ.
In this lesson
- Start with the claim that could be lost
- Build a profile across scenarios
- A small exposure cube by hand
- Tail exposure and the timing trap
- Turn the profile into a usable desk input
Before you start
- Market Model and Risk-Neutral Valuation
- Reduced-Form Models: Hazard Rates and Risk-Neutral Default Probabilities
The full lesson, with worked examples and exercise solutions, is for members.
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