FX Volatility Adjustment for Risk Factors Simulation

Abstract

This paper discusses a class of methodological issues that frequently arise in the risk management systems such as PFE and CVA engines. Simplified methodology and shortcuts come at a price, sometimes a steep one. To account for model deficiencies and disconnect between the calibration and the simulation modules, a number of adjustments to the risk factor simulation procedures must be made. As an example, FX volatility adjustment for risk factors simulation is considered. The impact on counterparty exposure numbers is quantified.

Keywords: Monte Carlo Simulation, Risk Engine, Volatility Adjustment, Counterparty Exposure

JEL Classification: G13, G15