Setting limits

Setting appropriate limits by counterparty will depend on both your risk tolerance
and the evaluation of the counterparty. For example, a reasonable approach employed
by many is to set the limits based on a percentage of their net tangible equity or net
asset value. Depending on your appetite for risk, you may want to set a limit of, say,
3% of any one party’s equity position. A similar percentage limit could be set off your
own liquid asset or equity position which would set the maximum exposure you
would want to any counterparty, however strong. These percentages would be
adjusted for the creditworthiness of the counterparty in question.
Once you have the credit evaluation structure in place the use of Credit-Value-at-
Risk (CVaR) is one way of estimating the potential credit exposure using a probability
distribution of price movements in the same way VaR is calculated for market risk.
This has particular relevance given the volatilities in power. Estimating this requires
the same fundamental information as VaR itself, including the current market price
for the contract, a price distribution, the magnitude of unpredictable price movements
(volatility and confidence interval) and the appropriate time it would take to rehedge
the position (holding period). The three latter components have distinctive traits in the
case of default since the event itself will be closely correlated with price movements.
A key issue is the determination of what volatility and time frame to apply. If we
take the example of Utility Y above, the trade was hedging an existing exposure six
months out and as such that hedge must remain for the entire period to minimize
the market risk. In addition, the magnitude of this event and the time it takes to
unwind positions will also depend on the market share of the defaulting party. The
immediate question that needs to be addressed is that if VaR is driven by the
assumption of normal market conditions, surely a default (being an abnormal market
event) makes it meaningless.
A starting point in solving this issue is to significantly lengthen the holding period.
A thirty-day holding period may be more appropriate in the instance of default rather
than the shorted period of, say, five days used of VaR itself. A credit risk manager
also needs to look at the potential movement of CVaR into the future as a way of
managing credit risk. In other words limits should be set on ‘potential exposures’ as
well as on CVaR itself. Graphing the predicted movements of exposure including
CVaR movements over the future duration of the portfolio provides a useful warning
of potential risks on the horizon, particularly given the seasonal nature of the
volatility outlined above. It is important to note that CVaR does not define your credit
risk (how likely you are to lose money) but it is a useful construct which will quantify
the likely exposure in the case of default.

The next step is to combine these risks with the probability of default and the likelihood
of multiple defaults (unfortunately all too common). This would allow you to estimate
the total portfolio credit risk to combine with the market risks within the book.
We can thus quantify two principal control points in setting credit policy – at the
individual level, the maximum potential exposure per counterparty, and at the macro
level, the credit risk within the book or portfolio. Both are fundamental to running a
well-managed energy trading book, although unfortunately while they provide strong
markers to how much risk is in the book they cannot accurately predict actual losses
in the case of default.