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The price is set at the inception of the agreement

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The price is set at the inception of the agreement and is valid until termination. To avoid being exposed to the volatility of prices, Utility Co. enters into long-term contracts (long-term supply agreements) with Traders & Co. Utility Co. agrees to buy a predetermined amount from suppliers in exchange for the commitment to be delivered a given quantity of oil . The purpose is to eliminate their exposure to the fluctuations of the market price and their CFs are known in advance . 100,000 oil per month is needed to be provided by the supplier Agreed Price is $3 The Contract is Valid for 5 years From a cash flow perspective, the price increases and so does the value (option). Each month the company need to pay $300,000 to supplier in exchange for oil. If the price goes up to $4 due to a strong economy: Utility Co. company made a good deal because they pay $3 only whereas the market price is now $4. Traders & Co. looses, as they were caught off-guard by the large price increase in the market due to a high volume of speculative bets. It is going out of business and stops all deliveries immediately due to bankruptcy. Therefore, Utility Co. must find another suppler. The graph shows the dollar loss for Utility Co. according to the prevailing oil price. The extra cost is: $100,000 x 12 months x ($4 – $3) = $1.2 million Hence 4 years is: 4 x $1.2 million = $4.8 million Therefore, the supply contract generated a credit risk for Utility Co. because when Traders & Co. defaulted, Utility Co. suffered a financial loss due to there being 4 years remaining on the contract, and the agreed price at time of default being $3 compared to the market price of $4 at time of default.
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What creates the dynamic exposure is the fact that the magnitude of the credit exposure depends on the market price at the time of the default . Each time the price of the product underlying the agreement changes, the credit exposure changes. The credit exposure can be calculated at any time, and it fluctuates with the price of the underlying product. Hence, it cannot calculate in advance , and its value will change frequently and can experience large swings in a short-period of time. Furthermore, the longer the time of the contract, the higher degree of uncertainty. 2. Why is Value at Risk (VaR) a critical tool for a credit risk manager? The Value at Risk (VaR) is an estimation of the expected maximum credit exposure , within a specific confidence interval and time horizon . VAR add a probability dimension to the MTM concept. It combines the predicted value and the likelihood of a price reaching a given value . Banks use VAR model, as higher accuracy. Risk managers have to choose a confidence interval that fits their risk appetite . If a high value is chosen, there is a good chance that the risk manager will never be surprised by bad news. However, this strategy has opportunity costs because the transaction is assigned a high GE and consumes a lot of the scarce credit capacity that a firm allocates to a counterparty . Other profitable transactions would be rejected due to lack of available capacity on the same counterparty .
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  • Fall '19
  • Debt, Bill Ramsey

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