Hi, thanks for this! However, the VaR you mentioned is Market VaR right? So what is the difference between Credit VaR and PFE then? As far as I understand, Credit VaR also measures the loss in case counterparty defaults?Hi LloydDagdag,
VaR is used to measure the market risk of a portfolio. PFE, as David mentioned, is used to measure the maximum potential loss in the case of credit events. Number of credit events are too few in a given time period compared to market events, meaning that number of exceptions may be too few to be able to make a sensible statistical analysis (backtesting).
Hope this makes sense.
"2.5.3 Potential future exposure: In risk management, it is natural to ask ourselves what is the worse exposure we could have at a certain time in the future? A PFE will answer this question with reference to a certain confidence level. For example, the PFE at a confidence level of 99% will define an exposure that would be exceeded with a probability of no more than 1% (one minus the confidence level). We see that the definition of PFE is exactly the same as the traditional measure of value-at-risk (VAR) with two notable exceptions:
This last point is important; VAR is trying to predict a worst-case loss whereas PFE is actually predicting a worst-case gain10 since this is the amount at risk if the counterparty defaults." -- Gregory, Jon. Counterparty Credit Risk: The new challenge for global financial markets (The Wiley Finance Series) (Kindle Locations 1502-1513). Wiley. Kindle Edition.
- PFE may be defined at a point far in the future (e.g. several years) whereas VAR typically refers to a short (e.g. 10-day) horizon.
- PFE refers to a number that will normally be associated with a gain (exposure) whereas traditional VAR refers to a loss.