Responsibilities of Credit Risk Management Pt. 2
In my previous blog, I offered the definition of credit risk as viewed by companies: the exposure of their counterparty’s inability to repay a debt, of which often fluctuates based on commodity price volatility. However, this term also describes the daily responsibilities of credit risk management deployed by credit personnel. This includes identifying, quantifying, monitoring, and mitigating credit risk. Understanding credit risk management can be difficult, but with a few definitions and examples, this practice becomes much simpler.
Surpassing the Jargon
An important aspect in identifying and quantifying credit risk is knowing the particular jargon used in credit risk operations. For example, it is important to be familiar with a letter of credit, which is a credit facility or financial guarantee provided by a bank on behalf of a party that, in the event of a valid unpaid claim against said party, permits a counterparty to draw funds from the bank. If this letter involves credit extension by the bank, it often contains a fee.
Another example is collateral, which is a form of credit assurance required for trading in the form of cash, short-term government securities, a letter of credit, or a guarantee. A collateral threshold is a credit exposure level — established in the governing credit agreement or Credit Support Annex of the ISDA Master Agreement — beyond which requests for liquid funds (collateral) are made to alleviate credit risk. It is two-sided in nature, one by a counterparty for a reference company and one by a reference company for a counterparty. Because they usually reflect the credit ratings of the parties involved, these two collateral threshold amounts do not need to be equal.
A collateral call is the amount by which credit exposure exceeds the collateral threshold, adjusted by the minimum transfer and rounding amounts specified in the controlling credit agreement. The call, minimum transfer, and the rounding amounts can be two-sided as well.
Applying Definitions to the Technique
In monitoring credit risk, organizational risk managers capture, survey, and set predefined credit risk thresholds and group them by commodity, counterparty, trader, portfolio, etc. As the thresholds begin to approach an organization’s limit, trading or risk managers begin receiving notifications. When the threshold exceeds its limit, trading activity for the commodity, counterparty, trader, or portfolio are halted. On the other hand, if a counterparty’s credit approaches predetermined thresholds, a relevant organization will require the counterparty to post currency in order to continue trading activity, or suspend activity until it receives a payment.
Stress testing is a common credit risk metric to simulate commodity pricing and mitigate credit risk. To clarify, this technique offers an organization forecasted exposure to lower or higher commodity pricing based off user-defined input. Mark-to-Market (MTM) refers to the estimated value of open deals or contracts at present market prices. A deterministic formula is used to estimate the MTM of physical deals, whereas derivative pricing models are used to estimate the MTM of financial deals.
With all of this information to keep in mind and constant changes within the trade industry, businesses need a solution to help them effectively manage operations and control all aspects of trading. The OATI Commodity Trading and Risk Management (CTRM) solution performs rear real-time valuation including Profit and Loss (P&L), streamlines deal capture and tracking, credit management, promotes forward trading, improves profits, and more. To learn more about how our CTRM solution provides full front-to-back office support for your company, please contact Sales@oati.net.
About the Author:
Mr. Jacob Cain has over 10 years of experience in the Commodity Trading and Risk Management industry. His experience includes energy and financial trading, energy scheduling and settlements, commodity risk management, renewable energy management, vendor solution selection and implementation, and fuel acquisition. As Account Executive at OATI, Mr. Cain oversees OATI’s strategy to provide optimal CTRM solutions to investment banks, power marketers, Independent Power Producers (IPPs), and hedge funds. His experience in commodity trading, scheduling, risk management, and settlements allows him to develop strategic recommendations with respect to a client’s CTRM business needs. Cain received his B.A. in Business Administration from Georgia Southern University and his MBA from the University of Tennessee.