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CSA Discounting: Impacts on Pricing and Risk of Commodity Derivatives

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DOI: 10.4236/jfrm.2014.33011    8,481 Downloads   10,218 Views   Citations
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ABSTRACT

The global financial crisis of 2007-2008 caused market practitioners to reassess the way in which financial derivative contracts had been priced during the preceding thirty years. The purpose of this paper is to examine the evolving practice of pricing and hedging commodity derivative contracts according to the terms of the Credit Support Annex (CSA). Using a series of case studies, we price crude oil swaps and Asian options in the pre-crisis, peak-crisis, post-crisis and recent market environments under two different frameworks: LIBOR discounting and CSA discounting (also referred to in a less general form as “OIS discounting”, which incorporates nearly risk-free interest rates). We also compute the widely used first-order and second-order Greek sensitivities. In each market environment, we shift the forward prices and implied volatilities crude oil and re-compute the trades’ valuation and Greek sensitivities at each incremental increase or decrease in price or implied volatility. Under each discounting framework, we quantify the change in trade valuation and Greek sensitivities that results from switching from LIBOR discounting to CSA discounting. The impact on the valuation and Greek sensitivities of a swap and an Asian option as the result of adopting CSA discounting can be significant under certain market conditions. There is likely to be larger impact on directional portfolios containing transactions that hedge either consumption or production (e.g. end users). Ceteris paribus, the impact on portfolio valuation and risk is likely to be limited for market participants (e.g. banks) with hedged portfolios that contain a large number of offsetting positions. Even though we focus our analysis on crude oil derivative contracts, the results easily extend to other asset classes such as natural gas, refined products, agriculture, metals, etc.

Conflicts of Interest

The authors declare no conflicts of interest.

Cite this paper

Abbate, R. (2014) CSA Discounting: Impacts on Pricing and Risk of Commodity Derivatives. Journal of Financial Risk Management, 3, 113-142. doi: 10.4236/jfrm.2014.33011.

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