Counterparty risk valuation for Energy-Commodities swaps: Impact of volatilities and correlation

TL;DR

This paper examines how volatilities and correlation between credit and commodities affect the valuation of energy-commodities swaps, emphasizing the importance of precise modeling over simple multipliers.

Contribution

It introduces a hybrid commodities-credit model to assess counterparty risk impacts on energy-commodities swap pricing, highlighting the roles of volatilities and correlation.

Findings

Counterparty risk significantly influences energy-commodities swap valuation.

Volatilities and correlation are crucial factors in accurate risk assessment.

Simple multipliers are insufficient for precise valuation.

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.