Credit Valuation Adjustment
for Commodity Derivatives Credit Risk Comes to the Forefront of Derivative Contract Valuations By Carlos Blanco
UNTIL RECENTLY, COUNTERPARTY risk management played a secondary role in the valuation and risk measurement of energy and commodity portfolios. The financial crisis, changes in accounting standards (FASB 157 in the USA, and IAS 39 elsewhere), as well as significant advances in credit risk measurement technology have led to an increased focus on improving counterparty risk management practices at energy and commodity firms. At the center of the credit risk methodology advances is the concept of Credit Valuation Adjustment, or CVA. CVA is the price of credit risk for a deal or portfolio of deals
with a given counterparty. Whenever we enter into a derivative contract, the counterparty (as well as ourselves) have the option to default. The CVA is similar to the premium that we should demand for selling that option. Figure 1 outlines the various
approaches used to calculate CVA. The first approach is relatively straightforward and just requires estimates of the probability of default of each counterparty to create credit- risk adjusted discount curves. The second and third approaches
Net Cash Flows
are more comprehensive but they rely on the availability of credit insurance contracts such as credit default swaps (CDS). A credit instrument that is specifically designed to offer protection against a set of counterparty exposures is the Contingent Credit Default Swap (CCDS). These instruments are similar to plain vanilla Credit Default Swap (CDS), but the protection payment in the event of default is based on the mark-to-market of a set of defined deals with a given counterparty. Unfortunately, CCDS are not actively traded and sellers of these contracts require large liquidity premiums. The first three approaches suffer from the limitation that the
Calculate net discounted cash flow for each future date using credit adjusted discount curve
Source: NQuantX, LLC Calculation of CVA
From a valuation perspective, the fair value measurements of derivative contracts should include a risk adjustment reflecting the amount market participants would demand because of the credit risk in the future cash flows that will be exchanged thought the life of the contract.
Calculating CVA requires estimating the risk neutral discounted loss with a given counterparty. That calculation is considerably more complex than calculating the mark-to-market assuming that there is no credit risk.
CVA = Mark to Market (risk-free) – Mark-to-Market (credit-adjusted)
credit exposure is assumed to be static, and therefore the CVA is not dependent on the volatility of the MtM of the deal. Due to the high volatility of most energy and commodity markets, this is a material deficiency that can seriously underestimate actual exposures. The fourth approach is based on simulated exposures. In addition to the forward curves and other market variables,
calculation is similar to CVAs but with two differences. Instead of potential positive exposures, we need to measure potential negative exposures; the discount curves used should be based on our own firm’s probability of default.
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CVA is a function of the volatility of market prices over time, the timing of cash inflows and outflows, the existence of collateral and netting agreements, the term structures of default probabilities as well as the expected recovery values. CVA can be unilateral or bilateral.
For assets (when the counterparty owes us money), we should apply the probability of default of the counterparty. The adjustment for our liabilities is known as Debt Valuation Adjustment (DVA). The
Figure 1: Approaches Used to Perform CVA
Net Current Exposure
Calculate Mark- to-Market and determine cost of insuring value of current MtM exposure
Cost of Buying Credit Protection
Determine net cash flow for future dares and calculate cost of credit protection
Exposure Based Methods
Potential positive and negative exposures for each counterparty taking into
account netting and collataral
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