Will your
customers or suppliers meet their future obligations?
Assessing,
Quantifying and Managing Buyer or Supplier Performance Risk in the
Physical World is the Challenge
Ron
Wells
In
the early eighties, against the backdrop of volatile market prices,
Bankers, Traders and Commodity Exchanges adopted value at risk (VaR)
calculations as the foundation on which to manage exposures that would
only crystallize in the future. The
widespread deregulation of markets for all sorts of commodities, as well
as financial instruments, and the increasing use of future fixed price
purchase and sale contracts has seen the associated performance risks
spread far beyond the realms of inter-bank, trader and commodity
exchange dealing. The
application of the Bankers’, Traders’ and Exchanges’ existing
techniques – involving VaR calculations and Margining – has likewise
spread.
This
article examines whether commercial Credit Managers should accept the
use of the “VaR and Credit VaR, Margining and the Right to Sue to
recover damages” formula as the most effective way to manage
Performance Risk and add value to their businesses.
It is pre-supposed that the function of the professional Credit
Manager is to add value to the business by providing competitive
advantage, while protecting the business from suffering catastrophic
losses.
Performance
Risk
In
light of the volatility of input and energy prices many firms are or
will be considering buying forward at fixed prices, and/or selling
forward at fixed prices, on term contracts.
Such contracts create performance risk.
Performance
Risk is not the same as Credit Risk.
The latter is the risk that a counterparty will not pay an
invoice in full, on the due date.
Performance
Risk is the risk that a counterparty will not deliver or will not accept
delivery of a physical product or service, at the agreed price, on the
agreed future date or series of dates.
A
company that relies on a forward contract (a contract that is at
inception intended to be settled by transfer of ownership of a physical
good in exchange for cash) will either (a) lose a profit opportunity, or
(b) incur an actual cash loss, if its counterpart to the contract fails
to deliver or accept the goods in question at the price contracted on
the agreed future date.
If
the company that relies on such a forward contract is able to pass on to
its customers the increased cost of purchasing substitute goods, it may
simply have lost an opportunity to realise the higher profit margin it
would have made if its supplier had not failed to deliver.
However
if the same company had itself contracted to deliver its final product
at a fixed price, relying on the fixed input price agreed with its raw
material, energy or transport supplier, it would suffer a cash loss when
meeting its obligation to its customer.
This
illustrates that Performance Risk has two main elements; firstly the question of whether or not the counterparty will
meet its obligation to deliver the agreed product of agreed quality in
the agreed quantity at the agreed price on time, and secondly what the quantum
of the loss would be if the counterparty were to fail to meet its
obligations.
The
focus of credit management practices so far, in respect of Performance
Risk, has been on attempting to quantify the maximum likely amount of
the loss that would be incurred by each party should the other fail.
It is in dealing with this challenge that ‘marked-to-market’
(m2m or m-t-m) and VaR (value at risk) analysis tools have been adopted.
Once
the possible potential future exposure (PFE) is quantified using these
tools, credit managers have turned attention to assessing whether a
counterparty that failed to deliver or purchase could and would pay
damages, at that maximum likely level, to the wronged company.
In this respect it is usual for the Credit Risk related
Probability of Default (PD) and Loss Given Default (LGD) factors to be
applied to the VaR calculation in order to complete the assessment.
Since Credit Risk and Performance Risk are fundamentally
different in nature, application of the PD and LGD factors is
inappropriate.
In
seeking to ensure that a counterparty will pay in due course credit
professionals have employed Margining techniques; together with the
inclusion in forward contracts of the rights (i) to require the
provision of Risk Mitigating Collateral – cash or guarantees - in
defined circumstances, and (ii) to Sue for Liquidated Damages.
In
large measure these techniques for calculating PFE and for assessing the
potential risk, seriously inhibit the propagation of additional
profitable business; in respect of transactions not involving banks,
major commodity trading houses and exchange traded instruments.
Value
at Risk (VaR)
VaR
calculations are mostly useless, for the purpose of estimating the
possible future exposure in relation to commercial transactions.
This is the case because they are always based on the assumptions
(1) that future prices can be predicted based on the trend and
volatility of prices observed in the past, and (2) that relevant price
trend and volatility data are available.
In
the first case it is clear
that the future cannot be predicted with any certainty based on the
extrapolation forward of past statistics; no matter how elegant the
formula used or how many tens of thousands of iterations are run through
powerful computers.
In
the second case, most
commercial markets for physical goods are micro-markets dependent on the
supply and demand for goods of a particular specification at the
particular time they are required, at the particular place where
delivery is desired. Trying
to fit commercial physical delivery of a particular type of good,
produced in certain quantities at a particular place – with attendant
particular transportation challenges and costs – into a calculation
based on a similar class of good traded on an exchange in another
country or region, which is often what is attempted, inevitably produces
misleading results.
Margining
and Legal Redress
Most
commercial end-users of products do not have the cash or the bank lines
available to provide daily settlement of the marked-to-market amount
that would in theory be due to the supplier should the buyer become
bankrupt within 24 hours. The
m2m amount referred to is the difference between the agreed forward
fixed price and the calculated or published potential future market
price. Hence the potential
loss that the supplier would suffer if the future price is lower than
the fixed forward price agreed. Most
of such buyers would also in all probability be judged not to be
financially able to pay the calculated maximum potential future
exposure.
The
upshot of an insistence on Margining and Legal Redress based on VaR
calculations (potential marked-to-market variances) is therefore all too
often the failure to secure otherwise profitable business transactions.
When
a credit management function repeatedly declines potentially profitable
business it fails in its primary objective, which is to actively manage
credit and performance risk, not to avoid or eliminate such risk.
As
the demand for goods and services has spread more evenly across the
planet; with the growth of construction, industrialisation and
consumerism in emerging markets, the demand-supply balance for many
products has destabilised leading to increased price volatility.
Naturally this leads businesses to turn to establishing forward
fixed price or linked-price purchase and/or sales contracts in order to
better predict profitable operations.
Thus commercial credit professionals are being challenged to find
ways to effectively manage Performance Risk.
There
must be many possible solutions so it is hoped that this article will
stimulate thought and discussion leading to development of some
alternatives to be included in the profession’s body of knowledge in
due course.
Opportunity
Motive and Means (OM2)
One
possibility when considering Performance Risk, as opposed to Credit
Risk, may be to consider:
•
Is the counterparty sufficiently hedged to tolerate any foreseeable
Potential Future Exposure? That
is to say, does it have a strategy or an arrangement that will enable it
to manage in the face of adverse price change, perhaps by having in
place an opposite position (such as a financial swap) or an ability to
adjust its retail prices to compensate.
•
Is the counterparty motivated to meet its commitments?
•
Will the counterparty have the financial means to pay?
Building a Performance Risk Management Process
Possible
building blocks for a performance risk management process could be:
•
Scenario Planning as a basis to estimate the Potential Future Exposure (
Opportunity
)
•
A Performance Risk ScoreCard to produce a Probability of Performance
Default (Motive)
•
A Recovery Rate Model to estimate the Loss Given Default (Means)
To view a related presentation click on this link: www.barrettwells.com/CVaREnergyRiskFeb2008web.pdf.
©
Copyright 2008 R K Wells
