TA model is presented to estimate conservative exposure for exotic equity linked notes. The estimated exposure is used for replacement risk monitoring as well as CVA calculation,
We assume that all products considered for conservative exposure approximation have limited upside potential. This limit corresponds to the maximum payoff. The exposure cannot exceed this limit and hence this limit is a conservative approximation for the exposure.
The model also assumes perfect correlation between underliers. Model owners state that this approach is conservative since individual equity volatilities for these options have never exceeded 40% historically.
For each product, the model describes the payoff function followed by the logic for transforming this function to an exposure approximation. We multiply the function by the quantity of the trade outstanding to approximate the exposure.
This model assumes a σ of 40% and a drift of zero. It also assumes perfect correlation among underliers. These assumptions mean that all baskets will behave identically, so the chooser feature is not applicable. Hence the maximum payoff is based on the return of any one of the baskets. At inception, the weight and quantity of assets assigned to each basket is such that the value of the basket equals its strike (which is usually 100). The model approximates the exposure by averaging the 95th percentile values of a stock with a spot price equal to the value of the basket at inception at each of the observation dates. The stock price dynamics are assumed to follow a geometric Brownian motion with a volatility of 40%.
Sensitivity of the model to change in input is zero since the conservative approximation approach calculates a maximum payoff exposure which doesn’t take into consideration changes in market data.