Introduction to Default Risk and Counterparty Credit Modelling

Laura Ballotta, Gianluca Fusai and Marina Marena

INTRODUCTION

The expansion of the liberalised 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 cashflows, generated by the assets and contracts in the portfolio, and the company economic-financial statements.

The most used derivative instruments for hedging purposes by oil, gas and power producers are commodity and interest-rate swaps; in these contracts, the floating leg is usually indexed either to the price of energy products, such as oil, natural gas and power, or to a Libor rate.

Commodity swaps are instruments traded over the counter (OTC), ie, the position is not managed by a central clearing house.11However, in the United States, most OTC derivatives must now be traded on organised trading venues and must be centrally cleared. In addition, the impact

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