A Note on the Impossibility of Correctly Calibrating the Current Exposure Method for Large OTC Derivatives Portfolios

Abstract

The capital charges for counterparty credit risk form an important part of the Basel Capital Accords. The Basel Committee permits firms to use a variety of methods to calculate regulatory capital on this risk class, including a simple approach – the constant exposure method or CEM – and a more sophisticated models-based approach known as EPE (for ‘expected positive exposure’). Counterparty credit risk capital models estimate the potential future exposure (‘PFE’) of a portfolio of derivatives with a counterparty based on whatever margining scheme applies. The CEM approximates this PFE using a constant percentage of notional, with the portfolio capital charge being the sum of the percentages which apply to each instrument. The CEM therefore recognizes no diversification benefit. In contrast, EPE approaches model the entire future of the net portfolio and thus provide much more accurate estimates for portfolios with more than a handful of instruments. The inaccuracy of the CEM is hardly surprising as it was intended only for smaller portfolios and less sophisticated firms. More recently the Basel Committee has proposed that the CEM be used as a method for determining the adequacy of financial resources available to an OTC derivatives central counterparty (‘CCP’). Since cleared portfolios are very large and very well-hedged, it might be imagined that the CEM is not well suited to this task. This paper confirms that suspicion. In particular we show that the use of the CEM to estimate the riskiness of CCP default fund contributions leads to a significant overstatement of risk. Further, we show that the CEM cannot be simply recalibrated to provide a more risk sensitive approach. Thus an approach which provides more accurate estimates for typical CCPs is to be preferred.