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Fuel Hedging and Risk Management: Strategies for Airlines, Shippers and Other Consumers


Praise for Fuel Hedging and Risk Management

"Risk Management is an art, not a science, but it certainly helps to know a lot of science. In this book, the authors provide an excellent overview of both qualitative and quantitative aspects of risk management and how to design and implement effective win-win fuel oil hedging strategies that will achieve the desired objectives under normal and extreme market conditions.

"In addition to discussing key foundational issues, the book also discusses a framework to understand and manage hugely important second-order effects, such as credit risk or margin calls or asset-liability mismatches, which have the potential to turn a good idea into a bad outcome. A must read for anyone in the finance department of a corporate, trade house, or financial firm involved in fuel oil hedging."
—Diego Parrilla, former Global Head of Commodity Solutions and Head of Commodities, Bank of America

"This book provides highly useful insights into hedging and risk management methodologies, as well as theory, for the users of energy products. Dafir provides intuition stemming from not just top-tier commodity structuring expertise, but also broader insight from his earlier experience as a credit derivatives and exotics trader."
—Mitch Matharu, former Head of Structuring, Merrill Lynch (Asia Pacific)

"An absolute must-read. From the fundamentals of oil markets to the key points in negotiating a credit agreement and minimizing hedging costs, passing by the subtleties of implied volatility surface construction and its implications in derivatives pricing, this book offers you the indispensable practitioner's toolbox, useful whether you are a novice or a seasoned fuel trader."
—Frederic Cogny, Global Head of Commodities Structured Products Trading, Standard Chartered Bank

"In this book, Dafir blends his deep knowledge of the commodity markets and the vagaries of the financial market with his incredible mathematical ability to explore fuel hedging in a manner accessible to Fuel Procurement Departments, CFOs and board members."
—Mark Long, former Head and Managing Director of Merrill Lynch Commodities Asia

"This book is a hands-on guide for anyone interested in fuel hedging and risk management, including lawyers involved in the execution of commodities hedging transactions and related ISDA and CSA negotiations."
—Justin Boyd, former Head of Financial Markets Legal, Standard Chartered Bank

SIMO MOHAMED DAFIR is a Managing Director at Volguard, a financial consulting firm specializing in Capital Markets, Wealth Management and Derivatives. He has over fourteen years of experience during which he has held senior positions in a number of major international banks in Hong Kong and Singapore. He was the Regional Head of Commodity Structuring at Standard Chartered Bank, Head of Commodity Exotics and Hybrids at Merrill Lynch Asia, and Trader of Credit Derivatives at Credit Suisse. He is also Professor of Global Financial Markets at Sorbonne Assas International Law School and an expert witness for financial markets litigations. Dafir started his career in Aerospace and Telecom at the European Space Agency and Alcatel. He holds an MBA from INSEAD, a Post Graduate Research Degree from the National Polytechnic Institute of Toulouse, an MSc in Automation from ENSEEIHT and a Bachelor's degree in Mathematics.

VISHNU N. GAJJALA is a commodity derivatives expert at Volguard, where he oversees the financial market analytics business. He has held positions in commodities structuring and sales at institutions including Standard Chartered Bank and Merrill Lynch, where he developed customized strategies for commodity hedgers and investors, including airlines, mining companies, trading houses, private banks and sovereign wealth funds. He holds a Bachelor's degree in Electrical Engineering from IIT Madras and an MBA from IIM Bangalore. Vishnu currently resides in Singapore.

Preface xiii

Acknowledgments xix

About the Authors xxi

CHAPTER 1 Energy Commodities and Price Formation 1

Energy as a Strategic Resource 1

Energy as a Tradable Commodity 3

Energy Commodities 5

Crude Oil 5

Oil Products 8

Natural Gas 11

Coal 11

Price Drivers in Energy Markets 12

Geopolitical Risks 12

The Geopolitical Chessboard - The Petrodollar System and Rising China 12

Long-Term Supply and Demand 15

Short-Term Supply and Demand: Supply Chain and Infrastructure 17

Financialization of Commodities 19

Market-Specific Price Drivers 19

Summary 20

CHAPTER 2 Major Energy Consumers and the Rationale for Fuel Hedging 23

Energy Market Participants 23

Risks Faced by Fuel Consumers - The Case of the Airline Industry 27

Airline Industry - Metrics and Operational Risks 27

Airline Industry - Financial Risks 30

Risks Faced by Other Major Fuel Consumers 35

Shipping Companies 35

Land Transportation 37

Oil Refining, Petrochemicals, and Power Generation 37

Industrial Users of Energy Commodities 38

The Case for Hedging 39

The Effect of Hedging on Airline Stock Price Volatility 39

Commodity Derivative Markets 41

A Brief History of Commodity Markets 42

Commodity Spot Markets and the Need for Standardization 43

Forward Contracts 44

Futures Contracts 45

Option Contracts 50

Summary 53

Appendix A 54

CHAPTER 3 Developing Fuel Hedging Strategies 55

The Rationale for Commodity Hedging 55

Developing a Fuel Hedging Program 57

Risk Identification and Assessment 57

Types of Risk 58

Risk Identification 59

Forecasting Prices and Conducting Simulations 59

Articulating the Firm’s Risk Appetite 60

Setting Objectives for Fuel Hedging and the Scope of Hedging 60

Identifying Risk Managers within the Organization 61

Determining the Scope of the Hedge Program 61

Implementation of Hedging 62

Selecting the Fuel Cost Management Method 62

Identifying the Underlying to Hedge with and Basis Risk 63

Quantity and Tenor of Hedging 66

Selection of Instruments for Hedging 67

Market Risk 68

Management of the Unwanted Risks of a Portfolio 68

Credit Risk 68

Liquidity Risk 69

Operational Risk 69

Legal and Reputational Risk 70

Monitoring and Calibration of the Hedging Program 70

Template for a Risk Management Policy 71

The Airline Industry - Trends in Fuel Risk Management 71

Magnitude of Fuel Price Risk 71

Underlyings and Hedging Instruments 73

Quantity and Tenor of Hedging 74

Recent Developments 75

Summary 75

CHAPTER 4 Shipping and Airlines - Basics of Fuel Hedging 77

Spot-Forward Relationships 77

Theories on the Shape of Forward Curves 78

Spot-Forward Relationships for Investment Assets 79

Spot-Forward Relationships for Commodities 80

Spot and Futures Volatility 81

Options 82

Call and Put Options 83

Put-Call Parity 84

Option-Based Hedging for a Shipping Company 85

Implied Volatility and the Black-Scholes Model 86

The Black-Scholes-Merton Model 88

Black’s Model for Pricing Options on Futures Contracts 89

The Greeks 89

Delta 90

Gamma 92

Theta 92

Vega 94

Rho 94

Higher-Order Greeks 95

Black’s Model Option Greeks 95

Asian Swaps and Options 96

Asian Swap-Based Hedging for a Shipping Company 97

Option Structures 97

Call Spreads and Put Spreads 97

Collars, Three-Ways, and Calendar Spread Options 99

Straddles, Strangles, and Butterflies 100

Capped Forwards 102

Capped Swap Usage for a Shipping Company 103

Derivatives Pricing 104

Stochastic Processes for Asset Prices - An Introduction 104

Brownian Motion and Wiener Processes 104

Itô’s Lemma 106

Option Pricing Using the Black-Scholes-Merton Formula 107

Asian Option Pricing 109

Summary 112

CHAPTER 5 Advanced Hedging and Forward Curve Dynamics 113

Swap and Vanilla Option-Based Structures 113

Zero-Cost Structures and the Usage of Options 114

Leveraged Swaps 114

Capped Swaps 116

Floored Swaps 117

The Volatility Surface 118

Multi-option Structures 119

Zero-Cost Collar 120

Three-Ways 120

Risk Reversals and their Hedging 121

Early-Expiry Options and Instantaneous Volatility Term Structures 122

The Samuelson Effect and the Storage Theory 122

Implied Volatility of Energy Futures Contracts 123

Early-Expiry Profile Construction 124

Commodity Swaptions and Extendible Swaps 127

Usage of Commodity Swaptions and the Reasons for their Popularity 127

Swaption vs. a Basket of Options 128

Understanding Commodity Futures Term Structures 133

The Normal Backwardation or Keynesian Theory 133

The Theory of Storage 134

Term-Structure Models 135

Schwartz’s One-Factor Model 135

Schwartz’s Two-Factor Model 136

Gabillon’s Model 137

Gabillon’s Stochastic Equation for Futures 138

Early-Expiry Profile Using Gabillon’s Model 139

Importance of Early-Expiry Profile for Exotic Products 139

Summary 140

CHAPTER 6 Exotic Hedging and Volatility Dynamics 141

Extendible Option Structures 142

Extendible Collar 142

Extendible Three-Ways 143

Cancellable - Extendible Parity 144

Pricing Extendible Option Structures 146

Volatility Models 150

Stochastic Volatility Models 150

Barrier Option-Based Structures 152

Knock-Out Options and Knock-In Options 152

Relationship between KI and KO Options 154

Knock-Out Swaps 154

Airbag Structure 154

KIKOs and Combinations of KI and KO Options 155

Accumulator Structures 156

European or Asian-Style Barrier Options 157

Barrier Payouts and Non-linearity - Digital Options and Replication 157

The Reflection Principle 160

Barrier Options Under the Black-Scholes Framework 161

Put-Call Symmetry 163

MTM Analysis of Barrier Options Under the Black-Scholes Framework 163

Pricing and Risk Management of Barriers with Real-World Constraints 165

Barrier Options on a Nearby Futures Contract 167

Local Volatility Models 168

Bermudan Extendible Structures 170

Valuation of Bermudan Extendibles 174

Longstaff-Schwartz Method and Exercise Boundaries 174

Extendible vs. Auto-callable Transactions 177

Bermudan Extendibles and the Forward Skew 177

The Inverse Leverage Effect in Commodities Markets 179

Target Redemption Structures 180

Target Redemptions and the 2008 Debacle 182

Defining Leverage 183

Target Redemption Pricing and Risk Management 184

The Mean-Reversion Trap 185

Target Redemption and Trading Risks 186

Sticky Strike and Sticky Delta 187

Sticky Strike Approach 187

Sticky Delta or Sticky Moneyness 188

Gamma/Theta Ratio 188

Summary 190

CHAPTER 7 Fuel Hedging and Counterparty Risk 191

The Importance of Valuation and Transaction Monitoring 191

Market Risk Management 192

Fuel Hedgers: Lottery Tickets and Spring Cleaning 193

Value at Risk 194

Liquidity Risk 195

Counterparty Risk 195

Credit Risk and Counterparty Risk 196

Expected Exposure 198

Potential Future Exposure 198

Measurement of Counterparty Risk for a Portfolio of Trades 198

Peak PFE 198

Common PFE Misconceptions and Pitfalls 200

Credit Exposure Optimization Techniques 202

Bilateral Netting Agreements 202

Credit Support Annexes 203

CSA Negotiations - Key Considerations 203

Funding Valuation Adjustment 206

Fuel Hedgers and FVA 207

The FVA Debate 209

The Price of Counterparty Credit Risk 209

Credit Derivatives and Credit Default Swaps 210

Credit Valuation Adjustment 212

Common CVA Mis-steps 213

Gap Options and Collateralization Agreements 213

Debt Valuation Adjustment 214

Fuel Hedgers and Debt Valuation Adjustments 214

The Case for Bilateral CVA 215

Wrong-Way Risk 216

Counterparty Credit Risk Hedging 216

Contingent CDS 216

Capped Exposure Derivatives 217

Summary 217

CHAPTER 8 Conducting Scenario Analysis 219

Scenario Analysis for Vanilla Products 220

Scenario Analysis for Path-Dependent Products 224

MTM-Based Scenario Analysis and Potential Future Exposures 229

Beyond Payoffs and MTMs - Collateralization and Funding Requirement Analysis 230

Hedge Effectiveness 231

Summary 233

CHAPTER 9 Financing and Risk Management: Bundled Solutions 235

Structured Aviation Finance Overview 235

Airline Financing via Debt and Aircraft Leases 238

Term Loans 239

Export Credit Agency Debt 240

Leases 240

Rationale for Combining Hedging and Financing 243

Reduction of Default Risk through Hedging 244

Oil-Linked Financing Structures 245

Flexible Oil-Insulated Lease 246

Cancellable Hedged Loans as Interest Cheapeners 250

Summary 252

CHAPTER 10 Applied Fuel Hedging - Case Studies 253

Case Study 1: YM Cargo Inc. 253

Business Risks 253

Operational Mitigants 254

Risk Appetite 255

Hedge Program Objectives and Scope 255

Implementation of Hedging 256

Portfolio Monitoring 260

Case Study 2: Worldwide Airlines 260

Evolution of WWA’s Hedging Strategy 262

Hedging Transactions Executed by WWA 264

Hedge Portfolio Analysis 267

Credit Lines and Collateralization Issues 269

Restructuring WWA’s Portfolio 271

Counterparty Risk and Funding Considerations for BMC 272

Summary 276

Bibliography 277

Index 281