Question
Can the potential future credit exposure (PFE) for short position CDS (see background) be capped to the sum of the outstanding premiums?
Background on the question
This question refers to credit default swaps (CDS) in the trading book, - which can be closed-out in case of insolvency of the counterparty, even though the underlying has not defaulted (for example when the CDS is part of a contractual netting agreement), - which is a short position in the underlying from the view of the reporting institute. According to Article 299(2)(a) CRR, the nominal value of such CDS shall be multiplied by 5% or 10% in order to calculate the potential future credit exposure (PFE). The PFE accounts for the potential risk from future market price raises of derivatives. CDS have an asymmetrical risk profile. The market price of a short position CDS cannot be higher than the (capitalized) outstanding premiums in any case. Thus, if the PFE is capped at the sum of the outstanding premiums, it would be adequately risk-averse.
Answer
Article 299(2)(a) of the regulation EU 575/2013 (CRR) states that under the mark-to-market method for the calculation of counterparty credit risk, the potential future exposure is determined by multiplying the notional amount by 5% or 10%. No reference is made to any situation where the above amount should be capped. Therefore, the PFE cannot be capped at the sum of the outstanding premiums for short position CDS. When arguing that this calculation method is not risk sensitive past a certain point, it should be noted that it is a simple method, which is therefore meant to be conservative.