If we have a portfolio of vanilla trades (say, swaps), we can calculate EAD on each trade individually (an example is discussed here). Naturally, it is tempting to say that the exposure on the portfolio is the sum of the exposures on individual trades. That’s very wrong because exposures are not additive.
Here is an example. Suppose we have a netting agreement with a certain counterparty, and at the moment we have a single trade with them: a semi-annual receiver swap of 6 month EURIBOR versus 4.08% fixed from 19 June 2009 to 19 June 2015. Below is the potential exposure profile of the swap at 95% confidence.
We see that the peak of the potential exposure profile is around 38. We want to add another trade to this portfolio: a semi-annual payer swap of 6 month EURIBOR versus 4.5% fixed from 19 June 2011 to 19 June 2017. Firstly, let us see the exposure profile of the new swap alone:
The peak exposure is around 34.
If we simply add the two peak exposures, we get 38+34 = 72. However, if we calculate exposure profile of the two netted swaps with a Monte Carlo simulation, we will see that the total exposure of the netted portfolio is much lower:
The peak is around 14, which is lower than each of the two swaps separately. Indeed, under the netting agreement the swaps partially compensate each other, so adding the second swap actually lowers our exposure to the counterparty.
Why would we have two trades that cancel each other out? It often happens in practice. Say, the receiver swap was done a while ago, and it still has a few years to go. Right now a trader needs a payer swap, so this swap is added to the portfolio.
To summarise: we have seen that the sum of exposures on individual trades can be very far from the total exposure on these trades covered by a netting agreement. The exposure profiles above are screenshots of MarketSimulator.