Hedging the Counterparty Credit Risk of an Oil Company with Oil Futures Using Dynamic GARCH – A Derivative's Approach to Right-Way Risk

Abstract

If the creditworthiness of a counterparty is a derivative of a commodity price, there is the potential to have right- or wrong-way exposures in commodity transaction. Identifying them is important, because otherwise credit costs are inadequately calculated. This is especially important if one wants to do more business in credit risky areas of the world.

As concerns publicly listed counterparties I develop a simple approach for identification of “Right Way Risk” (RWR). This approach only works if the stock and commodity price are cointegrated. To set the stage I subsume various models for optimal hedging under one general cointegrated model. In a worked example three models (Bivariate & Univariate Error Correction Model, Regression Model) are applied to the Chinese oil company Petrochina and RWR is shown for fixed price purchase contracts. The approach might help to get an accurate picture of credit risk and to structure commodity transactions more rewardingly.

Keywords: corporate risk management, right-way risk, GARCH, ECM, cointegrated system