Portfolio Compression: A Win-Win Case (Part 2/3)

Portfolio compressions can be useful to manage counterparty risk in derivative transactions. This article is the second of 3 parts and examines how companies can reduce potential future exposure. (This
September 14, 2014 - Editor
Category: EMIR

Portfolio compressions can be useful to manage counterparty risk in derivative transactions. This article is the second of 3 parts and examines how companies can reduce potential future exposure.

(This is part two of three, the first part is here: http://www.theotcspace.com/2014/03/21/portfolio-compressions-winners-and-losers-part-1-3)

I recall an unusual proposal from a counterparty when the company I was working in was facing financial difficulties. “My company” was selling gas to be delivered over several months in the future at a fixed price. We were making profits, meaning that if “My company” went into default, the counterparty (the buyer) would not lose any money from the deal. Nevertheless, the counterparty wanted to terminate the deal early. If they had nothing to lose, even if “My company” defaulted, why was this counterparty keen to terminate the transaction early?

Potential future exposure (PFE) is what the counterparty was concerned about. At the time of their proposal, the counterparty (buyer) was making losses. Volumes under the transactions were relatively large, and therefore if the market prices moved up, then their loss could have turned into a profit. And a large profit if prices increased significantly.

Making profits out of a company that is likely to default is not good news, as those profits may materialize to some extent only if claims from the administrator result successful. In other words turning into making profits might be good news for the front office, but imply taking credit risk.

Two important lessons from PFE:

  1. Credit risk is greater if open volumetric positions are larger.
  2. From the credit risk perspective, the buyer will be concerned about PFE in rising price scenarios. The seller will also be worried, because prices may drop.

From the potential future exposure perspective, whether a company buys or sells, the company should be concerned about concentrating large open volumetric positions for future deliveries to a counterparty. Therefore there is an incentive to reduce the volumetric position. Reducing PFE can help to accommodate a new attractive long-term deal with a counterparty with little room for more credit risk, or reduce the amount of collateral that needs to be posted, such as initial margin or independent amounts.

Win-Win: Compressing a portfolio with an open volumetric position

If the purpose of the compression is to reduce credit risk due to future price scenarios, then the compression should aim at closing a set of transactions with an open volumetric position. By reducing volumes, both “my company” and the counterparty will reduce the PFE to each other, and both could be winners from the credit risk perspective.

Compressing portfolios with open positions may make calculations and valuations a bit more challenging. First because to remain with the same overall position as before the compression, an off-setting transaction will be required. Also, the mark-to-market values need to be recalculated with new prices. On the other hand, portfolios with neutral positions have a fixed value because the market price effect is cancelled out from the valuation.

Credit risk and EMIR: Article 14a

One of the corners of the regulation has a requirement to analyse compression opportunities to reduce credit risk with counterparties with significant non-cleared derivatives. A PFE analysis should help identifying those opportunities.

In the next post I will cover compressions when counterparty netting is not feasible.

Diana Higgins

www.crediten.co.uk

 

 


Popular
Most Viewed

Image