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


Praises for Energy Trading and Risk Management

"Iris Mack's Energy Trading and Risk Management is built on the rare combination of decades of academic research and practical trading experience. A compelling and highly enjoyable book, this is essential reading for anyone wishing to succeed in today's increasingly complex and fast-paced trading arena where risk management clearly takes centre stage."
--Dr Guenther Dobrauz-Saldapenna, Technical & Markets Leader, R&C Services, PricewaterhouseCoopers, PwC, Zurich/Switzerland

"Iris Mack's book is a must read for those interested in the convergence of Energy and Financial Markets. View it as a short encyclopedia or a detailed navigator in this complex area. Being a strong quant and using a techno-fundamentalist approach Iris gives a clearly structured exposition understandable for beginners and catching for professionals. Be prepared for the fast-moving journey from the real-life basics and business cases to the rocket science formulas and if that’s not enough, find a reference to further reading after every topic touched."
--Dr. Alexei Kazakov, partner at AB Solutions

"Iris Mack's book Energy Trading and Risk Management is both a practical guide and a reference manual for anyone interested in investing in the rapidly developing energy trading markets. This remarkable book is a must have. It is an insightful tool that explains in detail the finer points in the use of derivatives as risk management tools. It delivers an easy to understand guideline while providing a whole vision about the industry, going through how the energy market works, who are the main players, in which kind of energy derivatives you could invest and how to create and manage risk in an energy portfolio, among many other factors."
--Eduardo Viesca Quiroz, Private Equity Investor

"Dr. Iris Mack's latest book Energy Trading and Risk Management is an ideal introduction to the topic. It helps professionals in both the energy and financial industries by providing a comprehensive overview of trading and risk management in these markets with its thorough coverage. This book includes case studies, illustrations, and trading models that make it an ideal read for trainers and professors. Clear and well-manifested graphical illustrations in the book make the toughest of concepts easier to grasp. This well-supported and structured work is for professionals who need a complete understanding of how energy markets work."
--Mohammad Asif, Director, JaZaa Financial Advisory Pvt. Ltd.

"Iris Mack's handbook serves as both gateway and reference to the complex world of energy derivatives. The theoretical foundations of every subject are treated with the utmost mathematical rigor, leading to a diligent treatment of hot topics in the energy derivatives industry. Each concept is expertly broken down and presented in an accessible manner, even to those less versed in stochastic calculus and quantitative finance. Energy Trading and Risk Management is highly valuable to all practitioners and academics seeking a one-stop reference to derivatives instruments, risk management and portfolio management in the energy industry."
--Dario Raffaele, ETRM Professional and Management Consultant, Accenture

IRIS MACK, PHD, EMBA, earned a Harvard doctorate in Applied Mathematics and a London Business School Sloan Fellow MBA. She is a former MIT professor and Derivatives Quant/Trader who has worked in financial institutions in the U.S., London, and Asia. She has also spent some of her professional career at NASA, Boeing, and AT&T Bell Laboratories – where she obtained a patent for research on optical fibers.

Dr. Mack lectures and consults on energy derivatives, quantitative finance, and high frequency trading, and serves on various boards, including National Academy of Sciences Transportation Research Board, AlgoAnalytics Trading and Financial Analytics (India), MarketExpress Financial News and Research (India), Women Mentor Women Foundation, and I Can Still Do That Foundation.

Dr. Mack founded Phat Math Inc. and The Global Energy Post in Miami, Florida. She and her colleagues at Phat Math launched their prototype mathematics edutainment social network Students in grades K-12 and college have access to free 24/7 online math homework help on — named one of the Top 50 Social Sites for Educators and Academics and 25 Useful Networking Sites for Grad Students.

Preface xiii

Acknowledgments xxv

About the Author xxvii

About the Contributors xxix

Chapter 1 Energy Markets Fundamentals 1

1.1 Physical Forward and Futures Markets 3

1.2 Spot Market 5

1.3 Intraday Market 10

1.4 Balancing and Reserve Market 10

1.5 Congestion Revenue Rights, Financial Transmission Rights, and Transmission Congestion Contracts 11

1.6 Chapter Wrap-Up 12

References 13

Chapter 2 Quant Models in the Energy Markets: Role and Limitations 15

2.1 Spot Prices 17

2.1.1 Random Walk Jump-Diffusion Model 19

2.1.2 Mean Reversion: Ornstein-Uhlenbeck Process 23

2.1.3 Mean Reversion: Schwartz Type 1 Stochastic Process 25

2.1.4 Mean Reversion with Jumps 25

2.1.5 Two-Factor Model 26

2.1.6 Negative Prices 27

2.2 Forward Prices 28

2.2.1 Forward and Futures Markets 28

2.2.2 Contango and Backwardation 30

2.3 Chapter Wrap-Up 31

References 31

Chapter 3 Plain Vanilla Energy Derivatives 33

3.1 Definition of Energy Derivatives 34

3.2 Global Commodity Exchanges 35

3.3 Energy Derivatives Pricing Models 36

3.4 Settlement 37

3.5 Energy Derivatives Quant Models: Role and Limitations 38

3.6 Options 40

3.6.1 Volatility 42

3.7 Vanilla Options 43

3.7.1 Option Style 44

3.7.2 Exchange-Traded and Over-the-Counter Options 44

3.7.3 In-the-Money, At-the-Money, and Out-of-the-Money Options 45

3.7.4 Put-Call Parity 46

3.8 European Options 47

3.9 American Options 50

3.10 Swaps 52

3.11 Swaps to Futures 54

3.12 Chapter Wrap-Up 54

References 54

Chapter 4 Exotic Energy Derivatives 59

4.1 Asian Options 60

4.1.1 Classes of Asian Options 61

4.1.2 Payoffs of Asian Options 62

4.1.3 Solutions to Asian Options 63

4.1.4 Asian Options in the Energy Markets 63

4.2 Barrier Options 63

4.2.1 Eight Types of Barrier Options 64

4.2.2 Partial Barrier Options 65

4.2.3 Solutions to Barrier Options 66

4.2.4 Barrier Options in the Energy Markets 66

4.3 Digital Options 66

4.3.1 Types of Digital Options 67

4.3.2 Solutions to Digital Options 69

4.3.3 Digital Options in the Energy Markets 69

4.4 Real Options 71

4.4.1 Real Options in the Electric Power Markets 71

4.4.2 Case Study: Real Options in the Oil Markets 72

4.4.3 Limitations of the Real Options Valuation Paradigm 73

4.5 Multiasset Options 74

4.5.1 Pricing Multiasset Options 74

4.6 Spread Options 75

4.6.1 Crack Spreads 76

4.6.2 Spark Spreads 82

4.6.3 Dark Spreads 85

4.7 Perpetual American Options 86

4.7.1 Perpetual American Options in the Power Industry 87

4.8 Compound Options 87

4.8.1 Tolling Agreements: Example of Compound Options in Power Markets 89

4.9 Swaptions 90

4.9.1 Energy Swaptions 91

4.10 Swing Options 92

4.11 Chapter Wrap-Up 94

References 94

Chapter 5 Risk Management and Hedging Strategies 99

5.1 Introduction to Hedging 102

5.2 Price Risk 104

5.3 Basis Risk 107

5.3.1 Basis Risk Case Study 108

5.3.2 Metallgesellchaft Case: Stack and Roll Hedging Disaster 109

5.4 The Option “Greeks” 110

5.5 Delta Hedging 111

5.6 Gamma Hedging 113

5.7 Vega Hedging 115

5.8 Cross-Hedging Greeks 116

5.9 Quant Models Used to Manage Energy Risk: Role and Limitations 116

5.9.1 Regression Analysis 117

5.9.2 Stress Test 120

5.9.3 Value at Risk 123

5.10 Chapter Wrap-Up 124

References 124

Chapter 6 Illustrations of Hedging with Energy Derivatives 127

6.1 Hedging with Futures Contracts 129

6.1.1 Case Studies and Examples: Hedging with Futures Contracts 130

6.1.2 Risks Associated with Hedging with Futures Contracts 138

6.2 Hedging with Forward Contracts 141

6.3 Hedging with Options 143

6.3.1 Case Study: Call Options Used to Set a “Cap” on Gasoline Prices 143

6.3.2 Example: How Power Generators Use Options on Futures to Hedge 144

6.3.3 Example: How End Users Utilize Options on Futures to Hedge 145

6.3.4 Example: How Power Marketers Use Options on Futures to Hedge 145

6.4 Hedging with Swaps 146

6.4.1 Example: Fuel Swap 148

6.4.2 Example: Electricity Swap 149

6.4.3 Case Study: Natural Gas Basis Swap 150

6.5 Hedging with Crack Spread Options 151

6.5.1 Case Study: Hedging with Crack Spread Options 153

6.6 Hedging with Spark Spreads 154

6.6.1 Case Study: Power Producer Uses Spark Spread to Protect Margin 154

6.7 Hedging with Other Energy Derivatives 157

6.8 Chapter Wrap-Up 158

References 158

Chapter 7 Speculation 161

7.1 Convergence of Energy and Financial Markets 162

7.2 Trading Terminology 167

7.3 Energy Products Trading Codes 169

7.4 Futures Trading Symbols: Month Code Abbreviation 170

7.5 Fundamental and Technical Analyses 171

7.6 Trading Tools: Charts and Quotes 173

7.7 Energy Trading Market Participants 176

7.8 Speculation in the Oil Markets 182

7.9 Speculation in the Electricity Markets 184

7.10 Speculation in the Natural Gas Markets 185

7.11 Chapter Wrap-Up 187

References 187

Chapter 8 Energy Portfolios 191

8.1 Modern Portfolio Theory 192

8.2 Energy Portfolio Management 196

8.3 Optimization of Electricity Portfolios 197

8.3.1 Case Study: Economic Load Dispatch of a Portfolio of Gas-fired Power Plants 199

8.4 Optimization of Gas Portfolios 201

8.5 Other Energy Portfolio Management Models 203

8.6 Chapter Wrap-Up 203

References 204

Chapter 9 Hedging Nonlinear Payoffs Using Options: The Case of a New Subsidies Regime for Renewables 207

9.1 Renewable Energy, Options Pricing, and Government Subsidies 209

9.1.1 Power Assets Modeled as a Vanilla Call Option 210

9.1.2 Strike Price of a Wind Turbine 211

9.1.3 Levelized Cost Price of Electricity 211

9.1.4 Wind Turbines’ Competitiveness on the Electricity Market 213

9.2 Government Subsidies as a Stochastic Process 216

9.3 Impact of Embedded Options and Stochastic Subsidies on Pricing and Risk Management 219

9.3.1 Pricing of a Wind Turbine and Subsidies as an Embedded Option 219

9.3.2 Tail Risk and Hedging Options with Options 222

9.4 Chapter Wrap-Up 224

References 225

Chapter 10 Case Study: Hydro Power Generation and Behavioral Finance in the U.S. Pacific Northwest 227

10.1 An Overview of Behavioral Finance 229

10.2 Behavioral Finance in Energy Economics 231

10.3 Power Generation in the Pacific Northwest 232

10.4 Behavioral Financing of Projects in the Pacific Northwest 235

10.5 Northwest Power Planning 239

10.5.1 Resource Availability 239

10.5.2 Resource Cost 239

10.5.3 System Flexibility 240

10.5.4 Cost Effectiveness 241

10.5.5 Transmission 241

10.6 Chapter Wrap-Up 241

Reference 242

Bibliography 243

Index 259