The discussion thus far has focused on calculating the credit exposure for a single transaction. It becomes more complicated, but extremely important, to obtain an accurate assessment of the total credit exposure on a portfolio of transactions with the same counterparty.
**Recommendation 11:. Aggregating Credit Exposures**

*Credit exposures on derivatives, and all other credit exposures to a counterparty, should be aggregated taking into consideration enforceable netting arrangements. Credit exposures should be calculated regularly and compared to credit limits. *

In calculating the current replacement costs for a portfolio of transactions with a counterparty, it is important to know whether netting applies (and is enforceable). If netting applies, the current credit exposure is simply the sum of the positive and negative mark-to-market values of the transactions in the portfolio. If netting does not apply, only the positive mark-to-market transactions should be added in calculating current exposure because the positive mark-to-market positions could not be offset against negative mark-to-market positions in the event of default.

It is more difficult to calculate measures of the potential exposure for a portfolio of transactions. The simplest method is again to simply add the measure of potential exposure of each transaction in the portfolio. Unfortunately, this procedure will in most cases dramatically overstate the potential exposure because it does not take into account transactions in the portfolio with offsetting exposures or with peak potential exposures that occur at different times.

Consider a counterparty with which two interest rate swaps have been executed. The swaps are identical in all respects except that in one swap the counterparty is receiving the fixed rate and in the other swap the counterparty is paying the fixed rate. Obviously there is no net exposure. Suppose we correctly calculate the total maximum exposure as $5 million for each transaction. If we add the exposures, the total maximum exposure on the portfolio would be $10 million. This is clearly an overstatement. If the counterparty was to default, only one of the swaps would result in a loss because both swaps could not have a positive mark-to-market value at the same time. The proper exposure in this portfolio is $5 million if netting does not apply and is zero if netting does apply.

Another shortcoming of adding the maximum exposures on a transaction-by-transaction basis in a portfolio relates to the timing of the default if one was to occur. Consider a portfolio in which there is a purchased interest rate cap and a long-term swap. Assume the last rate setting on the cap has taken place and that a final cap payment of $5 million is due in two months. The credit risk on the cap is $5 million. Assume that the swap was executed recently and the swap currently has a zero mark-to-market value and a peak maximum exposure of $6 million which will occur in two years (according to the hump-backed schedule discussed earlier). If we add the peak maximum exposures, the peak maximum exposure on the portfolio is $11 million.

This is clearly an overstatement. The peak maximum exposure on the cap occurs in two months and the peak maximum exposure on the swap occurs in two years. It is not appropriate to add the peak exposures of transactions that occur on different dates. In this situation, we should calculate the maximum exposure on the swap that could occur in two months. If that peak exposure is $2 million, we should conclude that the peak maximum exposure on the portfolio is $7 million, not $11 million.

The potential exposure of a portfolio of transactions with a given counterparty can be analyzed more thoroughly by simulation analysis. This requires sophisticated mathematical modeling and systems capability. In this approach, a statistical model generates multiple scenarios and investigates the stochastic properties of the derivatives portfolio. At each point in time under a given scenario, the mark-to-market value of each transaction in the portfolio is computed and the present value of the replacement cost of the entire portfolio is calculated, taking account of netting provisions where applicable.

This process is repeated for a large number of scenarios to generate a probability distribution of the present value of the replacement cost of the portfolio at each point in time. This information can be used to calculate the expected and maximum exposure profiles for the portfolio over its life span. The main advantage of this portfolio-level simulation is that it directly measures complex portfolio effects and thereby provides a much more accurate measure of expected and maximum potential exposure to a counterparty than would be obtained by aggregating exposures on individual transactions or by making an (educated) guess.

Market participants who do not have and cannot justify having the necessary simulation and statistical systems to perform such potential exposure calculations should use tables of factors developed under the same principles, making sure that the factors used differentiate appropriately by type of transactions and are adjusted periodically to reflect changes in market conditions and the passage of time.

It is extremely important to recognize that, much like current exposure, potential exposure also is constantly changing due to the passage of time and movements in the underlying variables (i.e., amortization and diffusion effects). Accordingly, calculations of potential maximum and expected exposures should be reviewed and updated to reflect these factors. Firms that aggregate potential exposures without quantifying portfolio effects through simulation analysis will generally overstate their counterparty exposure. Therefore, they do not need to perform calculations as frequently as firms that use simulation analysis to measure portfolio exposure more precisely. In any event, the frequency of calculation should be increased when credit limits are approached or exceeded.

Because it is relatively simple to calculate current exposures, and relatively more difficult to calculate potential exposure, several institutions update the current exposure on a daily basis but allow for potential exposure as a constant "add-on" to the current exposure. This "add-on" factor remains constant for the life of the transaction. This practice generally will result in a material overstatement of credit risk. This inaccuracy ignores the dynamic relationship between current and potential exposure and may be avoided by periodically updating the potential exposure calculations.

The Survey indicates that for dealers, the methods of aggregating derivatives exposures with a counterparty vary widely. Approximately one-third of dealers surveyed aggregate exposures with a counterparty by summing the exposures as initially calculated, while two-thirds of the dealers update aggregate exposures based, at a minimum, on the change in current exposure. Aggregation practices vary widely with respect to aggregating exposures on a net or gross basis. The diversity of practice probably reflects varying degrees of comfort regarding enforceability of netting in various jurisdictions. Thirty-four percent of dealers surveyed calculate aggregate exposures for credit line utilization purposes on both a net and gross basis. Fifty-nine percent of dealers surveyed calculate credit limit utilization solely on a gross basis, while only 5% calculate it solely on a net basis. It is also worth noting that the systems most dealers use to aggregate credit exposures are not able to automatically take into account the specific terms and conditions in the legal documentation pertaining to netting provisions. In the future, over three-quarters of dealers surveyed plan to develop such systems.

For purposes of credit limit utilization, there is wide diversity in how end-users aggregate credit exposures to a single counterparty. Specifically, approximately 28% use a net basis, 35% use a gross basis, 15% use both bases, and 22% have no formal credit limits. As expected, the responses to this question are extremely sensitive to the home country of the end-users. In the United States, where netting is widely accepted and legally enforceable, 57% of all respondents use a net basis and 61% intend to do so. In contrast, only 11% of end-users in the United Kingdom use a net basis and 56% use a gross basis.

The discussion on current and potential exposure emphasized that credit risk is a dynamic concept that changes with the passage of time and with movements in the underlying variables. The Survey showed that three-quarters of all dealers monitor counterparty exposures on an intraday or overnight basis and 87% of the dealers can review derivatives exposures as needed between reporting intervals. Moreover, 95% of dealers surveyed have information on credit exposures and credit line availability for new derivatives transactions in the dealing room, with an even split between paper-based systems and on-line computer systems. However, it is important to note that, while most dealers regularly update and monitor measurements of current exposure, only 23% of dealers surveyed review the factors that influence potential exposure as frequently as quarterly. Forty-four percent of those surveyed report that they review potential exposure only on an *ad hoc* basis.

Sixty-one percent of end-users surveyed report that they measure the counterparty exposure of all derivatives products on an ongoing basis over the life of the transaction. Moreover, 75% of all respondents plan to follow this procedure. A majority of end-users report that they monitor their derivatives exposures to counterparties on a monthly or quarterly basis. Forty-two percent monitor exposures monthly and 26% do so quarterly. Sixty-nine percent of end-users surveyed have the capacity to review derivatives counterparty exposure as needed during intervals between reporting periods.

Most end-users update their exposure calculations to reflect the passage of time over the life of the transaction. Specifically, two-thirds of end-users measure overall risk to a counterparty based on the remaining maturity rather than the original maturity of the transactions. Three-quarters of all respondents plan to adopt the practice.

The Survey results indicate that many dealers recognize the importance of aggregating the measurement and integrating the analyses of exposure from derivatives transactions with exposures from more traditional on-balance-sheet banking products. Almost half of the dealers surveyed currently aggregate exposures from derivatives and non-derivatives activities across all products and all business lines; 73% of those surveyed intend to do so in the future. Approximately one-third of the dealers have credit systems for derivatives that are fully integrated with on-balance credit systems and almost three-quarters of the dealers plan to have such fully integrated systems.