Exposure model

The exposure model is depicted in Figure 10.6. This portion of the model aggregates
the portfolio of assets across business lines and legal entities and any other appropriate
category. In particular, netting across a counterparty would take into account
the relevant jurisdiction and its netting laws. Without fully aggregating, the model
cannot accurately take into account diversification or the lack of diversification.
Only after the portfolio is fully aggregated and netted can it be correctly priced. At
this point the market risk pricing model and credit risk pricing model can actually
price all the credit risky assets.
The exposure model also calculates for each asset the appropriate time period,
which roughly corresponds to the amount of time it would take to liquidate the asset.
Having a different time period for each asset not only increases the complexity of the
model, it also raises some theoretical questions. Should the time period corresponding
to an asset be the length of time it takes to liquidate only that asset? To liquidate
all the assets in the portfolio? Or to liquidate all the assets in the portfolio in a time
of financial crisis? The answer is difficult. Most models simply use the same time
period, usually one year, for all exposures. One year is considered an appropriate
amount of time for reacting to a credit loss whether that be liquidating a position or
raising more capital. There is an excellent discussion of this issue in Jones and
Mingo (1998). Another responsibility of the exposure model is to report the portfolio’s
various concentrations.