The importance of Counterparty risk was risen during the financial crisis of 2007, after the collapse of several financial institutions during that time. It is used as a measure of the exposure of a financial entity to a counterparty, regarding financial instruments like derivatives, and incorporates both credit risk and market exposure. Using Counterparty risk, we can estimate the exposure of a firm to a counterparty, using market factors and the amount of potential losses, if the counterparty goes on default, using credit risk factors.
Counterparty risk gives rise to directional risk, which can be defined as the risk of potential market movements and consists of Right Way Risk and Wrong Way Risk. For the purposes of this report, we are just going to provide the definition of Right Way Risk, so as to address the concept of Wrong Way Risk in more depth. Right Way Risk is defined as the situation where the creditworthiness of the counterparty of a transaction is improving, as the payment obligation of this transaction increases as well. Recent regulatory frameworks, have indicated Right Way Risk as a desirable property of a potential financial transaction.
Wrong Way risk
Wrong Way Risk can be defined as the case in which the two sources of risk move in the same direction. This means that there is a positive correlation between the credit exposure of one counterparty and the probability of default of the other counterparty. It essentially means that the payment ability of a counterparty deteriorates as the exposure on the traded position is increasing. Wrong Way Risk is not desirable in any financial transaction and its severity was reflected in the recent financial crisis, where Wrong Way Risk amplified potential losses that counterparties already suffered due to the crisis. That is the reason of the gradual increase of regulation regarding the nature and management of Wrong Way Risk, as established by the Basel III accords especially in the over the counter (OTC) items and derivative items of a financial entity.
The following graph shows the positive relationship between the difference in credit spread and the difference in exposure, which is the definition of Wrong Way Risk, as stated before. The credit spread is used as a proxy for the credit quality of a counterparty since it rises as the credit quality of a financial entity deteriorates.
Graph 1: Wrong Way risk
Cases of directional risk can be presented in portfolios of equity or CDSs (credit default swaps) or even commodities derivatives. On the other hand, for portfolios of Foreign Exchange (ForEx) and interest rates, directional risk does not play a significant role. This report will try to shed more light on the Wrong Way Risk and its effects on commodity derivatives.
An example of Wrong Way Risk in the commodities derivatives could be between a large gold mining and producing company and a bank. The two counterparties agree on a forward contract in which the bank pays the spot price of gold and receives a fixed rate. If the price of gold was to decrease, the value of the aforementioned forward contract for the bank would increase, because the bank agreed to pay on the falling spot rate. On the other hand, the credit quality of the gold mining company would get worse, since their profits would reduce, thus increasing the possibility of not being able to pay, which makes the company’s probability of default further increase.
Credit Valuation Adjustment (CVA)
The most commonly used practice for Wrong Way Risk estimation in the financial markets is the Credit Valuation Adjustment (CVA). CVA is used as readjustment of the market value of a derivatives portfolio for the credit worthiness of the counterparty, under the assumption that there is a hypothetical risk-free counterparty. Thus, CVA can be defined as the difference between the value of a default free portfolio and the value a portfolio which includes the probability of default of the counterparty.
The use and proper estimation of CVA is critical for banks and financial institutions because it gives them the flexibility to look further above the credit risk analysis, in order to be able to dynamically hedge, price and in general manage counterparty risk. This is the reason why more and more banks develop their internal credit risk desks within their derivatives desks, to manage counterparty risk in derivatives transactions. Of course, while the advantages of CVA are not to be disregarded, banks should be cautious with the range of information they use and with the way this information is used, since there maybe differences between the way other financial institutions use them.
The formula for the CVA estimation is the following:
CVA=(1-RR) * ?_(i=1)^n??DFi*EPEi*DPi?, where
RR is the Recovery Rate, which indicates the amount the can be recovered from a defaulted security.
DFi is the risk-free discount factor.
EPEi is the Expected Positive Exposure, which is the weighted average over time of the expected exposure.
DPi is the internal probability of default of the counterparty.
The following parts of the report refer to the Excel spreadsheet and the calculations made in the VBA code to calculate with the CVA of a commodity forward.