June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 49 of 92 This chapter will go into some depth as to how companies can approach each of the following aspects identified above: 1. Expected Default Probability (EDP) 2. Default Rate Volatilities and Correlations 3. Recovery Rate and Recovery Rate Volatility 4. Credit Rating Migration 5. Econometric Factors 6. Current and Potential Credit Exposures (PFE) It is important to understand how the various credit risk mitigation tools work together to provide an optimal level of credit protection. 5.2. Expected Default Probability (EDP) Before we discuss the specifics of determining default probability, it is important to highlight a couple of distinct challenges inherent in credit risk management in the energy industry. When evaluating counterparties, one of the most important aspects is answering the question “Who am I dealing with?” In today’s corporate structures, the web of relationships can make it very confusing as to who is actually at the other end of the transaction. This becomes more acute when determining default probability. Whose default probability should be calculated? Also, this brings up the issue of parent guarantees. In dealing with a subsidiary of another company how confident are you that the parent will support the subsidiary in the case of credit issues? These are questions that should be answered prior to initiating the default probability calculations. To the extent possible, companies should endeavor to build databases that address these issues and incorporate their regular maintenance into the routine risk management infrastructure. 16 One other aspect that should be considered is that the default probability calculated determines the probability of default on a company’s loan payments it does not compute a default probability on the performance of a contract, which is what most commodity transactions are concerned with. There are certain events, such as Force Majeure events, that will not force loan default, but will however cause non- performance on a contract.17 For the purposes of this paper, we will assume that a 16 Energy Modeling. Credit Risk Management for the Energy Industry – Some Perspectives. V. Kaminsky, V. Shanbhogue. Risk Books. 2005. pp. 339. 17 Energy Modeling. Credit Risk Management for the Energy Industry – Some Perspectives. V. Kaminsky, V. Shanbhogue. Risk Books. 2005. pp. 348-49.