Estimating Swap Potential Future Exposure Across Payment Dates
Summary
The document explains how to estimate pre-settlement risk, or potential future exposure (PFE), for a five-year interest rate swap. Although its question asks whether payments from the counterparty should be constant, the answer clarifies that exposure is the swap’s changing value if rates move, not simply the scheduled coupon amount.
One approach assumes a flat yield curve, shifts rates to a level representing the 95th percentile in the exposure’s favor, and reprices the swap at successive dates as its remaining tenor shortens. A simulation alternative generates rate-curve changes under an interest-rate model and takes the 95th percentile of favorable swap values at each date. The answer describes a typical profile that rises, peaks roughly a third of the way through the swap, and then falls toward zero, while noting that the curve shape affects the profile. This is a high-level outline: it does not specify a rate model, calibrate inputs, or provide a worked calculation or plotted results, so implementation choices remain open.
Key ideas
- PFE measures potential future swap value, rather than equal scheduled payments.
- Reprice the swap at each date using a favorable rate shift and the shorter remaining tenor.
- Alternatively, simulate rate-curve changes and use the favorable 95th percentile of swap values.
- A typical exposure profile rises and then declines, but depends on the yield curve.
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Full text
# Interest Rate Swap Pre-Settlement Risk
# Interest Rate Swap Pre-Settlement Risk
I am kind of confused about how to approach the following question.
Suppose I enter into a interest rate swap (IRS) with counter party C. Details are : Fixed rate rate receiver, floating rate payer :C;
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Duration : 5 years,
Coupon payments: quarterly,
Notional Principal: 100 million
Fixed Rate: 4% per annum quaterly basis.
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Given the interest rates follows a normal distribution with mean standard deviation 10perecent; and 95 percent confidence interval.
What is the pre settlement risk of counterpart C at each payment date over the tenure, and plot the risk of 20 potential credit exposure.
Answer: Shouldn't all the payment from Counter party C should all be the same? I am not getting the concept or how to approach this question.
Thanks
## Answer by cykor21 (score 2)
https://quant.stackexchange.com/a/33529
- Pre-Settlement (potential future exposure PFE) calculation at 20 payment dates: assume a model for the floating interest rate: might be a constant across all maturities for simplicity (flat yield curve) shift the yield curve to 95th percentile in your favor calculate the price of the swap at each time point (remember that tenor of the swap shorten as you move forward) using the shifted yield curve
Alternatively: you can simulate interest-rate (yield curve) shifts for example 1k times using an interest-rate model and then take out 95th percentile of swap prices in your favor at each time point - this will be your PFE
- the shape of the credit risk profile for a generic swap is increasing to a maximum point ( this will be around duration/3 time point) and then decreasing to 0 but details depends on the yield curve shape: for a upward sloping yield curve you can expect to have negative cash-outflows in the second half of the contract tenor as your floating rate should be higher than fixed rate
The process for pre-settlement risk calculation can be found in the literature.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.