Against a backdrop of price volatility, cost pressures, compliance, and competition, managing a commodity trading firm in today’s landscape is far more complex than it has been before. Despite this, many firms are still relying on traditional, manually intensive methods to evaluate and respond to risk.
Counterparty risk is the biggest risk faced by commodity firms, primarily due to the complexity in hedging it. This risk can be categorised into settlement risk and pre-settlement risk. Settlement risk can be hedged by insurance.
Pre-settlement risk on open contracts is largely managed by establishing limits and monitoring of exposures such as Mark-to-Market (MTM) and Potential Future Exposure (PFE) against those limits. Until recently, there has not been a systematic effort to quantify this risk using measures like Credit Valuation Adjustment (CVA). However, there is a shift underway, with some firms, particularly those in the energy sector, looking to adopt CVA and other Valuation Adjustments (VAs) under the XVA framework from financial markets for pricing and valuing commodity trades.
Commodity firms have begun systematically pricing XVA on their portfolios. Emulating best practices from financial markets, early adopters of XVA, offers valuable insights for effective implementation. For commodity players without existing XVA systems, they have the option to either purchase a third-party solution or develop one internally.
Contents
- Counterparty risk and XVA complexity
- Bridging the gap: adopting XVA
- Pricing complexity of commodity instruments
- Wrong-way risk and devaluation
- Implementing XVA in commodity risk management
