Energy Trading and Risk Management : A Practical Approach to Hedging, Trading and Portfolio Diversification

[Book Description]

A comprehensive overview of trading and risk management in the energy markets Energy Trading and Risk Management provides a comprehensive overview of global energy markets from one of the foremost authorities on energy derivatives and quantitative finance. With an approachable writing style, Iris Mack breaks down the three primary applications for energy derivatives markets Risk Management, Speculation, and Investment Portfolio Diversification in a way that hedge fund traders, consultants, and energy market participants can apply in their day to day trading activities. * Moving from the fundamentals of energy markets through simple and complex derivatives trading, hedging strategies, and industry-specific case studies, Dr. Mack walks readers through energy trading and risk management concepts at an instructive pace, supporting her explanations with real-world examples, illustrations, charts, and precise definitions of important and often-misunderstood terms.* From stochastic pricing models for exotic derivatives, to modern portfolio theory (MPT), energy portfolio management (EPM), to case studies dealing specifically with risk management challenges unique to wind and hydro-electric power, the bookguides readers through the complex world of energy trading and risk management to help investors, executives, and energy professionals ensure profitability and optimal risk mitigation in every market climate. Energy Trading and Risk Management is a great resource to help grapple with the very interesting but oftentimes complex issues that arise in energy trading and risk management.

[Table of Contents]

Preface                                            xiii

Acknowledgments                                    xxv

About the Author                                   xxvii

About the Contributors                             xxix

    Chapter 1 Energy Markets Fundamentals          1    (14)

      1.1 Physical Forward and Futures Markets     3    (2)

      1.2 Spot Market                              5    (5)

      1.3 Intraday Market                          10   (1)

      1.4 Balancing and Reserve Market             10   (1)

      1.5 Congestion Revenue Rights, Financial     11   (1)

      Transmission Rights, and Transmission

      Congestion Contracts

      1.6 Chapter Wrap-Up                          12   (3)

        References                                 13   (2)

    Chapter 2 Quant Models In the Energy           15   (68)

    Markets: Role and Limitations

      2.1 Spot Prices                              17   (11)

        2.1.1 Random Walk Jump-Diffusion Model     19   (4)

        2.1.2 Mean Reversion:                      23   (2)

        Ornstein-Uhlenbeck Process

        2.1.3 Mean Reversion: Schwartz Type 1      25   (1)

        Stochastic Process

        2.1.4 Mean Reversion with Jumps            25   (1)

        2.1.5 Two-Factor Model                     26   (1)

        2.1.6 Negative Prices                      27   (1)

      2.2 Forward Prices                           28   (3)

        2.2.1 Forward and Futures Markets          28   (2)

        2.2.2 Contango and Backwardation           30   (1)

      2.3 Chapter Wrap-Up                          31   (52)

        References                                 31   (52)

    Chapter 3 Plain Vanilla Energy Derivatives     83

      3.1 Definition of Energy Derivatives         34   (1)

      3.2 Global Commodity Exchanges               35   (1)

      3.3 Energy Derivatives Pricing Models        36   (1)

      3.4 Settlement                               37   (1)

      3.5 Energy Derivatives Quant Models: Role    38   (2)

      and Limitations

      3.6 Options                                  40   (3)

        3.6.1 Volatility                           42   (1)

      3.7 Vanilla Options                          43   (4)

        3.7.1 Option Style                         44   (1)

        3.7.2 Exchange-Traded and                  44   (1)

        Over-the-Counter Options

        3.7.3 In-the-Money, At-the-Money, and      45   (1)

        Out-of-the-Money Options

        3.7.4 Put-Call Parity                      46   (1)

      3.8 European Options                         47   (3)

      3.9 American Options                         50   (2)

      3.10 Swaps                                   52   (2)

      3.11 Swaps to Futures                        54   (1)

      3.12 Chapter Wrap-Up                         54   (4)

        References                                 54   (4)

    Chapter 4 Exotic Energy Derivatives            58   (41)

      4.1 Asian Options                            60   (3)

        4.1.1 Classes of Asian Options             61   (1)

        4.1.2 Payoffs of Asian Options             62   (1)

        4.1.3 Solutions to Asian Options           63   (1)

 

        4.1.4 Asian Options in the Energy          63   (1)

        Markets

      4.2 Barrier Options                          63   (3)

        4.2.1 Eight Types of Barrier Options       64   (1)

        4.2.2 Partial Barrier Options              65   (1)

        4.2.3 Solutions to Barrier Options         66   (1)

        4.2.4 Barrier Options in the Energy        66   (1)

        Markets

      4.3 Digital Options                          66   (5)

        4.3.1 Types of Digital Options             67   (2)

        4.3.2 Solutions to Digital Options         69   (1)

        4.3.3 Digital Options in the Energy        69   (2)

        Markets

      4.4 Real Options                             71   (3)

        4.4.1 Real Options in the Electric         71   (1)

        Power Markets

        4.4.2 Case Study: Real Options in the      72   (1)

        Oil Markets

        4.4.3 Limitations of the Real Options      73   (1)

        Valuation Paradigm

      4.5 Multiasset Options                       74   (1)

        4.5.1 Pricing Multiasset Options           74   (1)

      4.6 Spread Options                           75   (11)

        4.6.1 Crack Spreads                        76   (6)

        4.6.2 Spark Spreads                        82   (3)

        4.6.3 Dark Spreads                         85   (1)

      4.7 Perpetual American Options               86   (1)

        4.7.1 Perpetual American Options in the    87   (1)

        Power Industry

      4.8 Compound Options                         87   (3)

        4.8.1 Tolling Agreements: Example of       89   (1)

        Compound Options in Power Markets

      4.9 Swaptions                                90   (2)

        4.9.1 Energy Swaptions                     91   (1)

      4.10 Swing Options                           92   (2)

      4.11 Chapter Wrap-Up                         94   (5)

        References                                 94   (5)

    Chapter 5 Risk Management and Hedging          99   (28)

    Strategies

      5.1 Introduction to Hedging                  102  (2)

      5.2 Price Risk                               104  (3)

      5.3 Basis Risk                               107  (3)

        5.3.1 Basis Risk Case Study                108  (1)

        5.3.2 Metallgesellchaft Case: Stack and    109  (1)

        Roll Hedging Disaster

      5.4 The Option "Greeks"                      110  (1)

      5.5 Delta Hedging                            111  (2)

      5.6 Gamma Hedging                            113  (2)

      5.7 Vega Hedging                             115  (1)

      5.8 Cross-Hedging Greeks                     116  (1)

      5.9 Quant Models Used to Manage Energy       116  (8)

      Risk: Role and Limitations

        5.9.1 Regression Analysis                  117  (3)

        5.9.2 Stress Test                          120  (3)

        5.9.3 Value at Risk                        123  (1)

      5.10 Chapter Wrap-Up                         124  (3)

        References                                 124  (3)

    Chapter 6 Illustrations of Hedging with        127  (34)

    Energy Derivatives

      6.1 Hedging with Futures Contracts           129  (12)

        6.1.1 Case Studies and Examples:           130  (8)

        Hedging with Futures Contracts

        6.1.2 Risks Associated with Hedging        138  (3)

        with Futures Contracts

      6.2 Hedging with Forward Contracts           141  (2)

      6.3 Hedging with Options                     143  (3)

        6.3.1 Case Study: Call Options Used to     143  (1)

        Set a "Cap" on Gasoline Prices

        6.3.2 Example: How Power Generators Use    144  (1)

        Options on Futures to Hedge

        6.3.3 Example: How End Users Utilize       145  (1)

        Options on Futures to Hedge

        6.3.4 Example: How Power Marketers Use     145  (1)

        Options on Futures to Hedge

      6.4 Hedging with Swaps                       146  (5)

        6.4.1 Example: Fuel Swap                   148  (1)

        6.4.2 Example: Electricity Swap            149  (1)

        6.4.3 Case Study: Natural Gas Basis Swap   150  (1)

      6.5 Hedging with Crack Spread Options        151  (3)

        6.5.1 Case Study: Hedging with Crack       153  (1)

        Spread Options

      6.6 Hedging with Spark Spreads               154  (3)

        6.6.1 Case Study: Power Producer Uses      154  (3)

        Spark Spread to Protect Margin

      6.7 Hedging with Other Energy Derivatives    157  (1)

      6.8 Chapter Wrap-Up                          158  (3)

        References                                 158  (3)

    Chapter 7 Speculation                          161  (20)

      7.1 Convergence of Energy and Financial      162  (5)

      Markets

      7.2 Trading Terminology                      167  (2)

      7.3 Energy Products Trading Codes            169  (1)

      7.4 Futures Trading Symbols: Month Code      170  (1)

      Abbreviation

      7.5 Fundamental and Technical Analyses       171  (2)

      7.6 Trading Tools: Charts and Quotes         173  (3)

      7.7 Energy Trading Market Participants       176  (6)

      7.8 Speculation in the Oil Markets           182  (2)

      7.9 Speculation in the Electricity Markets   184  (1)

      7.10 Speculation in the Natural Gas          185  (2)

      Markets

      7.11 Chapter Wrap-Up                         187

        References                                 187

    Chapter 8 Energy Portfolios                    181  (26)

      8.1 Modern Portfolio Theory                  192  (4)

      8.2 Energy Portfolio Management              196  (1)

      8.3 Optimization of Electricity Portfolios   197  (4)

        8.3.1 Case Study: Economic Load            199  (2)

        Dispatch of a Portfolio of Gas-fired

        Power Plants

      8.4 Optimization of Gas Portfolios           201  (2)

      8.5 Other Energy Portfolio Management        203  (1)

      Models

      8.6 Chapter Wrap-Up                          203  (4)

        References                                 204  (3)

    Chapter 9 Hedging Nonlinear Payoffs Using      207  (20)

    Options: The Case of a New Subsidies Regime

    for Renewables

      9.1 Renewable Energy, Options Pricing,       209  (7)

      and Government Subsidies

        9.1.1 Power Assets Modeled as a Vanilla    210  (1)

        Call Option

        9.1.2 Strike Price of a Wind Turbine       211  (1)

        9.1.3 Levelized Cost Price of              211  (2)

        Electricity

        9.1.4 Wind Turbines' Competitiveness on    213  (3)

        the Electricity Market

      9.2 Government Subsidies as a Stochastic     216  (3)

      Process

      9.3 Impact of Embedded Options and           219  (5)

      Stochastic Subsidies on Pricing and Risk

      Management

        9.3.1 Pricing of a Wind Turbine and        219  (3)

        Subsidies as an Embedded Option

        9.3.2 Tail Risk and Hedging Options        222  (2)

        with Options

      9.4 Chapter Wrap-Up                          224  (3)

        References                                 225  (2)

    Chapter 10 Case Study: Hydro Power             227  (16)

    Generation and Behavioral Finance in the

    U.S. Pacific Northwest

      10.1 An Overview of Behavioral Finance       229  (2)

      10.2 Behavioral Finance in Energy            231  (1)

      Economics

      10.3 Power Generation in the Pacific         232  (3)

      Northwest

      10.4 Behavioral Financing of Projects in     235  (4)

      the Pacific Northwest

      10.5 Northwest Power Planning                239  (2)

        10.5.1 Resource Availability               239  (1)

        10.5.2 Resource Cost                       239  (1)

        10.5.3 System Flexibility                  240  (1)

        10.5.4 Cost Effectiveness                  241  (1)

        10.5.5 Transmission                        241  (1)

      10.6 Chapter Wrap-Up                         241  (2)

        Reference                                  242  (1)

Bibliography                                       243  (16)

Index                                              259