Relevance
PFE is essential to bank regulation under Basel III and Dodd Frank. Fundamentally, to assess the safety of a bank's asset portfolio and the adequacy of its Tier 1 capital (and Tier 2 capital), one needs to evaluate whether it is resiliant under severely stressing market moves.
Using option's strategies, it is easy for a trader to set up a "Black Swan" type trade that will pay a moderate money upfront, but yield catastrophic losses if the underlying securities' price moves above a certain "out of the money" strike price. This is akin to writing a large amount of insurance contracts against a rare but catastrophic risk. The vast majority of the time - and for many years running - the trader can appear to have a highly profitable strategy (even if the trade actually had negative expected value). When the rare event occurs, the person (or more likely her employer) who wrote the "insurance" (or in options terminology - the person who was "short a put or call" / "shorted volatility" / was "short gamma") sustains massive losses and may go bankrupt. These sorts of trades are behind most major collapses in the past 30 years - including much of the savings and loan crisis of the 1980s, Kidder Peabody, Enron, AIG, Lehman and even recent (relatively "small") losses at JP Morgan.
These crashes indirectly tax the vast majority of citizens who did not gain from the trading profits and did not choose to bear these risk. Essentially it can socialize losses while keeping profits private. This is for two main reasons. First, government directly (or indirectly) insures many retail deposits (to prevent bank runs and to promote savings), and many quasi-government agencies (ex : FNMA, Freddie Mac) have defacto government backing. Second, even when a major firm does not have government insured deposits, it can be "systemically important" (such as AIG) - its failure would potentially cause panic, destroy market liquidity, and precipitate a crash and potential widespread economic contraction / depression. (This is the reasoning behind "too big to fail".)
For these reasons, regulation needs to evaluate and respond to potential future risks. PFE is one important measure in this regard.
Read more about this topic: Potential Future Exposure
Famous quotes containing the word relevance:
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—Elizabeth Bowen (1899–1973)
“... whatever men do or know or experience can make sense only to the extent that it can be spoken about. There may be truths beyond speech, and they may be of great relevance to man in the singular, that is, to man in so far as he is not a political being, whatever else he may be. Men in the plural, that is, men in so far as they live and move and act in this world, can experience meaningfulness only because they can talk with and make sense to each other and to themselves.”
—Hannah Arendt (1906–1975)
“Wherever the relevance of speech is at stake, matters become political by definition, for speech is what makes man a political being.”
—Hannah Arendt (1906–1975)