What is Potential Future Exposure (PFE) used for?

Potential Future Exposure (PFE) is a risk management measure that is used to evaluate the maximum potential loss an institution could face at a specific future date due to counterparty credit risk. PFE is particularly important in the context of derivatives and trading portfolios where the exposure to a counterparty can change over time as market conditions fluctuate. By assessing PFE, financial institutions can estimate the worst-case scenario for their potential loss, enabling them to allocate capital effectively and manage counterparty risk comprehensively.

This focus on estimating future losses is essential for implementing effective risk mitigation strategies, such as collateral agreements or credit limits, which help ensure that potential exposures are kept within acceptable boundaries. Therefore, its primary purpose lies in understanding and preparing for future risk scenarios rather than assessing current market conditions, historical volatility, or liquidity aspects of an asset.