Counterparty Risk Valuation for Energy-commodities Swaps: Impact of volatilities and correlation
by Damiano Brigo of FitchSolutions & Imperial College,
June 24, 2008
Abstract: It is commonly accepted that Commodities futures and forward prices, in principle, agree under some simplifying assumptions. One of the most relevant assumptions is the absence of counterparty risk. Indeed, due to margining, futures have practically no counterparty risk. Forwards, instead, may bear the full risk of default for the counterparty when traded with brokers or outside clearing houses, or when embedded in other contracts such as swaps. In this paper we focus on energy commodities and on Oil in particular. We use a hybrid commodities-credit model to asses impact of counterparty risk in pricing formulas, both in the gross effect of default probabilities and on the subtler effects of credit spread volatility, commodities volatility and credit-commodities correlation. We illustrate our general approach with a case study based on an oil swap, showing that an accurate valuation of counterparty risk depends on volatilities and correlation and cannot be accounted for precisely through a pre-defined multiplier.
Keywords: Counterparty Risk, Credit Valuation adjustment, Commodities, Swaps, Oil models, Convenience Yield models, Stochastic Intensity models.