Potential Future Exposure of Target Redemption Forwards

Abstract

We calculate the PFE of TARFs using both a smile aware Heston model and a smile unaware Garman-Kohlhagen (GK) model. Results show that the FX Heston model tends to produce significantly different PFEs than the GK model, highlighting the importance for a dealer’s global simulation model to accurately capture 1) the distribution of the underlying spot rate, and 2) the joint distribution of the underlying and its implied volatility surface.

Keywords: PFE, FX Heston, Garman-Kohlhagen, Monte Carlo, FX Option, TARF, TARN

JEL Classification: C60