Energy Derivatives

New Developments and Challenges

Alexander Eydeland
Morgan Stanley
New players in energy derivatives
markets
Traditional users of energy derivatives:
energy producers, marketers and end-
users.
Main objective: to hedge energy exposure
New players: investors - banks,
institutional investors, hedge funds
Increased interest in commodity-linked
products: the investors point of view
spectacular returns in the last few years
diversification
historically commodity returns are weakly correlated
with equity or fixed income products and can be used
as a separate asset class (Gorton and Rouwenhorst,
2004)
protection against inflation caused by economic
growth
commodities are correlated with non-economic
drivers: weather, environmental issues, supply
constraints, etc.
Increased interest in commodity-linked
products: the issuer point of view
Frequently the products can be split into
several components that can be used as a
long-term hedge of existing commodity
market risks - a useful feature particularly
when the markets are illiquid
Example 1. Product: Energy commodity-linked bond.
Issuer: Credit Suisse, 1998. Time maturity: 10 years.
At redemption, holder receives par, In addition, holder receives
semi-annual coupon. Each coupon is calculated according to the
formula:
Coupon = .73 x Percent_Gain
NYMEX_WTI
In this formula the coupon is calculated using percentage gain of the
NYMEX WTI contract during the coupon period, provided that this
gain is positive. For example, if during the coupon period the
NYMEX WTI contract moves up from $50 to $55 per barrel, coupon
payment on $1000 par bond will be .73*(.1)*1000 or $73. Next
coupon would be determined using a new base price of $55.
Example 2. Product: Energy commodity-linked note.
Issuer: Canadian Imperial Bank, 1998. Time to maturity: 5 years.
The note payment is determined by the price of the underlying
basket consisting of a weighted combination of the light sweet crude
and natural gas. If the basket price drops, the note holder receives
par at maturity. If it increases, holder receives
Par x (1 + 1.1 x Percent_Gain
Basket
)
If the basket price moves from $10 to $11 the holder of $1000 par
bond receives $1000*(1+1.1*.1) = $1110
Example 3. Product: Commodity-linked note.
Issuer: Sao Paolo IMI, 1998. Time to maturity: 5 years.
Underlying index: a basket of petroleum, copper, gold, aluminum
and zinc. Holder is guaranteed 17% gain even if the price of the
basket drops. At maturity, holder is paid
Par x (1 + 1.2 x Percent_Gain
Basket
)
If the basket price has moved from $100 to $120 holder receives
$1240
There are similar products involving energy
commodities; mostly, oil products or natural gas (rarely,
electricity)
New Developments: Increased volume and
complexity
Examples:
The issuer guarantees that the sum of all coupons is greater than a
specified percentage value. If the value is not reached over the life
of the product, the deficit is compensated at maturity.
Coupon dependent on the history of commodity prices during the
coupon period, and not just on one price at the coupon payment
day. For example, it may depend on the sum of all previous coupon
payments.
Various deal interruption condition can be included such as note call
provisions, or stipulations that the product will be terminated when
commodity prices reach specified levels.
Frequent feature: use of baskets of instruments as an
underlying index
Baskets:
may consist entirely of energy commodities
may include, in addition to energy commodities, other commodities,
such as metals
may be combination of commodities with practically any other group
of indexes
we often witness products dependent on combination of crude,
natural gas, metals, SP500, Treasury yields, LIBOR, etc.
Creation of these baskets has become progressively easier in recent
years with popularization of the Goldman-Sachs Commodity Index
(GSCI) and its various sub-indexes
Hybrid Products
Depend on several market/non-market drivers
We interested in hybrid products which are
exposed to at least one commodity
Pricing requires analysis of correlation structure
(in addition to volatility)
Hybrid Products: Examples
Price/Price spark spread options, crack spread options
Price/Volume load following deals
Price/Temperature products
Basket products Rainbow options, Himalayan options
Interest rates/FX/Equity contingent commodity products
swaps, swaptions
Credit/Commodity products cds linked to commodity
price
Spark Spread Options
Tolling deals
call on power with strike price dependent on the cost of fuels,
emission and variable costs = option on spread between power
prices and prices of fuels and emission
basket of correlated commodity products (three or four products
in the basket)
objectives:
power operator will guarantee stable cash flows stream (option
premium) typically from an institution with higher credit rating
power plant operator may also use these options to hedge against
adverse power and fuel market movements
marketers use these options to financially replicate power plant
operation without taking on operational and other risks associated
with running the plant
Tolling Deals: Examples
Unit Contingent Toll with Callback on High Gas
Standard Toll: Buyer has the right to call for power. When the
right is exercised the buyer pays the cost:
Number MWh x Price of 1MMBtu of NG x Heat Rate + costs
Callback: Seller has the right not to deliver power during not
more than 10% of all hours of the year (if a specified unit is
forced out)
Tolling Deal with Limited Number of Start-ups during the
year - complex path-dependent option
Tolling deals with fuel substitution option
Challenges: Correlation Structure
Correlation has a complex term structure: seasonality,
dependence on time to maturity
Correlation smile: in Black-Scholes-type models used
to price complex spread options correlation parameters
may depend on underlying prices
Example: Correlation vs Power_price/NG_price
Price/Volume Products
Swing options
Load following contracts
receiving fixed payments
paying costs of serving the load: Price x Load
Challenges:
Potentially strong non-linearity (if the correlation is high)
Complex correlation structure
Inability to hedge all risks, particularly, risks associated with load
fluctuations and load shape dynamics
Need new approaches to valuation
Basket Products
Options on basket price
basket components may include crude, NG, equity indices,
bonds, etc.
Rainbow or Best-of basket products
pays the best annual return of the basket components
Himalayan option
every year pays the return of the best performing basket
component and then this component is removed from the basket
Challenges:
Finding distribution of basket prices
How to construct the volatility structure of the basket from the
volatility structures of the individual components?
Commodity-contingent interest rate/equity
products
Commodity-contingent interest rate swap
floating leg - LIBOR
fixed leg - fixed rate multiplied by the number of days
(expressed as a fraction of the payment period) during which
crude or other commodity prices are above a certain level
Commodity-contingent interest rate swaption (typically,
Bermudan style)
Bermudan-style commodity-contingent guaranteed
minimum coupon knock-out option
Pays coupon dependent on the commodity price levels at the
payment time
Disappears after the total coupon reaches a specified level
If at the end of the deal the total value of paid coupons is less
than the specified value the last coupon pays the difference
Modeling challenges
Test: terminal distributions of returns at any
time T is normal - justification for the use of geometric
Brownian motion (GBM) as a modeling process
SP500: distribution of returns is close to normal
T T
dP P
Modeling Challenges
Power, NG and crude prices: normality must be rejected;
distribution has fat tails
Modeling Challenges
Crude: Fat tails of the distribution
Modeling Challenges
Distribution Parameters (A. Werner, Risk Management
in the Electricity Market, 2003)
3.33 0.004 23% DAX
76.82 2.079 238% NP 6.p.m.
26.34 1.468 182% Nord Pool
Kurtosis Skewness Annual.
Volatility
Empirical characteristics of energy
commodities
Implied volatility surface:
implied volatility increases with time
volatility depends on strike
In addition, for spread options we must consider
Correlation surface:
Correlation depends on time to expiration
Correlation depends on time between contracts
Correlation depends on strike (heat rate, in case of
spark spread options)
WTI futures implied volatility curve
Correlation between returns of Jan 04 NYMEX WTI futures
contract and Feb04 - Jun05 WTI contracts
Volatility has smiles, smirks, and frowns
Stochastic Volatility (Heston, 1993)
Volatility is a random variable
price process
volatility process
1
( )
t
t
dP
dt v t dW
P
= +
( ) ( )
( )
2
( ) dv t v t dt v t dW = +
( )
1 2
E dW dW dt =
Stochastic volatility process generates more
realistic price distributions
Tails of CDF for terminal distributions generated by
stochastic volatility process and by GBM
New Developments
Levy Stable Processes (for review see Boyarchenko
and Levendorskii, 2002 )
Levy Processes with Stochastic Volatility: CGMY
model (Carr, Geman, Madan, Yor, 2003)
Regime-switching models
Historic Power Prices vs. GBM paths
Hybrid Power Price Model
Power is a function of principal drivers
1. Demand
2. Fuel Prices
3. Outages
Hybrid Power Price Model
(Eydeland, Wolyniec, 2001)
Model uses fundamental and market data
s
gen
- function determined by technical characteristics of
all power plants (efficiency, operational constraints, etc.)
D - demand
U - fuel(s) used
- outages
( )
1 2 3
( ; , , , , , )
gen
T T T T T T T
P s D T U E VOM C =
Hybrid Model generates realistic paths
Actual prices vs. Modeled prices
Risks
Quantifiable risks
market/price risk
credit/default risk
modeling/valuation risk
financing/financial risk
operations risk
volumetric risk
business continuity risk
environmental risk
Source: Committee of Chief Risk Officers
(CCRO), 2002
Non-quantifiable risks
strategic risk
operational risk
staffing/organization risk
regulatory risk
political risk
technological risk
legal risk
Managing market price risk
Two methods of risk reduction
Diversification
Hedging
Hedging in the perfect world
V - option value
F - price of a tradable instrument (for
example, futures price)
f - option pricing formula (for example,
Black-Scholes)
( ) V f F =
Hedging in the perfect world
Delta Hedging:
Combine long position in one option
and short position in futures
V
F

Hedging in the perfect world

Change in option value vs. change in hedge value
Hedging = risk reduction
Reduction of the uncertainty of the future cash flows
Energy deals and assets =
spread options
Power plants, tolling contracts = spark
spread options
Gas storage = calendar spread options
Transmission lines, pipelines, transmission
right contracts = geographical spread
options
Power Plant
In the simplest case (immediate response
to price changes, one fuel -- natural gas),
the plant cash flow at time T:
C -- capacity
HR -- heat rate
P
T
and G
T
are power and nat. gas prices at time T
VOM -- variable costs
0
max( ,0)
T
t t
t
CF C P HR G VOM
=
=

Hedging spread options in the perfect

world
What is needed for valuation and hedging?
Joint distribution
Evolution processes for power and fuel prices
Cashflow function
Sufficient amount of tradable hedge instruments
(futures, forwards, options)
Hedging in energy markets: real world
Mismatch in asset/hedge maturities: long maturity of assets
vs. short maturity of hedges
Mismatch in granularity: fine (daily, hourly) granularity of
assets vs. coarse (monthly, quarterly) granularity of hedges
Mismatch in underlying commodity, dirty hedges.
For example, fuel contracts in one location are used to
hedge exposure in other locations
Hedging in energy markets: real world
Liquidity constraints:
Price may depend on the volume
Execution time may depend on the volume
Wider bid/ask spreads
Higher hedging costs
distributions are hard to calibrate because of
biases due to liquidity constraints
implication: different hedging strategies may
produce different option values
Hedging in energy markets: short and
medium term
Hedge instruments are available although the
set of hedges is not complete and mismatches
persist
Consequently, hedges are dirty resulting in
residual cashflow variance
Liquidity, in general, is not a problem for medium
size deals
Possible to follow the perfect world hedging
methodology
Hedging in energy markets: short and
medium term
Problems in defining the right evolution
process
empirical power price data shows mean
reversion, spikes, high kurtosis, regime
switching; processes difficult to calibrate due
to lack of data and its non-stationarity
Hedging in energy markets: short and
medium term
How is the joint distribution defined?
Typically, by supplying correlation coefficient implicitly assuming
that the joint distribution belongs to the elliptic family of
distributions
The correlation coefficient is computed using historical data
Problem: correlation coefficient between power and natural gas (or
oil) is not a constant; it has structure. Taking average will
overestimate the option and miscalculate hedges
Hedging in energy markets: short and
medium term
Other issues:
Standard approach will have difficulties
incorporating structural changes of the stack
or demand
Unlike cashflows of financial products, the
cashflows of energy assets are determined by
complex operating strategies: dispatch
strategy for power plants or
injection/withdrawal strategy for gas storage
Alternative Method: Hybrid Model for Power
Prices
Model uses fundamental and market data
s
gen
- function determined by technical characteristics of
all power plants (efficiency, operational constraints, etc.)
D - demand
U - fuel(s) used
- outages
( )
1 2 3
( ; , , , , , )
gen
T T T T T T T
P s D T U E VOM C =
Hybrid method
The benefits of the method:
captures distribution properties (high kurtosis,
spikes, volatility and correlation structure)
correlation is not an input
matches market data
allows incorporation of future structural
changes
Hedge efficiency
Back testing of hedging
Managing other risks
Credit risk - credit derivatives
Operational risk - insurance
Demographic, economic growth risks -
contractual clauses
All this increases the cost of risk
management; these costs should be taken
into consideration at the valuation stage
References
Boyarchenko, Svetlana and Sergei Levendorskii, Non-Gaussian Merton-Black-
Scholes Theory, World Scientific, 2002
Eydeland, Alexander and Krzysztof Wolyniec, Energy and Power Risk
Management: New Developments in Modeling, Pricing and Hedging, Wiley,
2002
Carr, Peter and Helyette Geman, Dilip Madan, Marc Yor, Stochastic Volatility for
Levy Processes, Mathematical Finance, Vol. 13, No. 3 (2003)
Rouwenhorst, K. Geert and Gorton, Gary B., "Facts and Fantasies about
Commodity Futures" (February 28, 2005). Yale ICF Working Paper
Heston, Steven, A Closed-Form Solution for Options with Stochastic Volatility,
Review of Financial Studies, Vol. 6, No. 2 (1993)
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