What is counterparty credit risk?

All transactions give rise to counterparty risks. These risks include the failure to deliver goods or perform services within the timeframe specified in a contract, as well as the failure to respect the transactions’ inherent financial obligations.

Counterparty credit risk refers to the loss incurred by one party in the event that the other fails to meet its financial obligations, either partially or totally. In order to quantify this risk, it is appropriate to look at both the probability of a company not meeting its financial commitments [the "probability of a credit event"] and the amount that its counterparts would receive in such an event. This risk amount can be expressed as the expected loss on the underlying commercial contract and can be represented as the probability of the credit event multiplied by the loss that the event gives rise to (ie. the amount that is not recovered).

When a corporation cannot or is unwilling to meet its financial obligations, its creditors force it into bankruptcy. The creditors are then awarded certain amounts by the liquidators. This amount will vary according to the seniority and security of the claims, and the funds available for distribution from the liquidation of the firm's assets. Each trade creditor will receive a recovery amount from the proceedings, but it is difficult to determine the exact amount that will be recovered.

Enron’s products have been designed to address counterparty credit risk directly. They correspond to the actual risks of non-payment inherent in all commercial transactions.

For example, consider a company that has a $10 million exposure to another. If the company purchases a bankruptcy swap for a notional amount of $10 million, it will receive the $10 million if the counterparty is declared bankrupt or insolvent. Any amount recovered from the liquidation proceedings is additional income for the swap buyer, who is effectively over-protected by having purchased a swap with a $10 million notional face value. Furthermore, if the buyer has a view on the amount of that it can recover from a certain counterparty (eg. 30% of the claim), it could purchase a swap with a notional value of $7 million instead of $10 million, and hence have a better (and cheaper) hedge.

Enron prices credit risk into all commercial transactions. Since credit risk is dependent on a large number of variables, its pricing is a complex issue. Credit risk is priced at the transaction level via models using Monte Carlo simulation of several stochastic variables. Some major elements of the simulation model are the internal counterparty credit assessment (which is used to derive both the probability of a bankruptcy occurring and the estimated recovery rate), price volatility of the underlying asset, interest rates and any credit enhancements.

Estimation of Probabilities of Bankruptcy

Each Reference Entity is subjected to a rigorous credit assessment based on publicly available information and internally generated market and credit analysis. The credit quality of counterparties is monitored and updated in real-time as a function of market movements and specific events.

Estimation of Recovery Rate

The application of a recovery rate to the credit exposure gives the expected loss upon bankruptcy. It is very difficult to estimate the market expectation of recovery rates for different types of obligations.  Enron uses its own experience, publicly available historical data and internal analysis to estimate the recovery rate on its counterparties’ obligations, which is then incorporated into the analysis of individual contracts.

Enron’s credit products provide customers with the ability to maximize the benefits of instantaneous pricing and credit exposure management.

To discuss the theory behind Enron's approach to pricing credit, please e-mail us at Credit-Desk@enron.com or phone +44 (0)20 7783 4242.