Handbook of Multi-Commodity Markets and Products: Structuring, Trading and Risk Management

CHAPTER 16 Pricing Commodity Swaps with Counterparty Credit Risk: The Case of Credit Value Adjustment

Marina Marena, Gianluca Fusai and Chiara Quaglini

16.1 INTRODUCTION

16.1.1 Energy Company Strategies in Derivative Instruments

The expansion of the liberalized physical commodity markets has led to the development of financial derivative instruments linked to energy commodities; this was followed by an increase in the number of energy companies acting as market operators both with hedging and trading purposes. It is acknowledged by energy companies that their activities expose them to relevant market and credit risks. For this reason the companies should measure, manage and limit these risks to maintain both the stability of cash flows, generated by the assets and contracts in the portfolio, and the company economic–financial balance. The most used derivative instrument for hedging purposes by oil, gas and power producers is the commodity swap. The floating leg of the commodity swap is usually indexed to oil products.

Since the commodity swap is an instrument traded over the counter (OTC), which is not managed by a central clearing house, it is necessary to estimate and quantify within the pricing activity the counterparty credit risk. This can be done by entering specific agreements such as the margining agreement, the exchange futures for physical, the additional collateralization or simply by adjusting the OTC derivative instrument risk-free value with a metric called credit ...