Energy Trading and Risk Management: A Practical Approach to Hedging, Trading and Portfolio Diversification / Edition 1

Energy Trading and Risk Management: A Practical Approach to Hedging, Trading and Portfolio Diversification / Edition 1

by Iris Marie Mack
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Energy Trading and Risk Management: A Practical Approach to Hedging, Trading and Portfolio Diversification / Edition 1

A comprehensive overviewof trading and risk management in the energy markets 

Energy Trading and Risk Management
provides a comprehensiveoverview of global energy markets from one of the foremostauthorities on energy derivatives and quantitative finance. With anapproachable writing style, Iris Mack breaks down the three primaryapplications for energy derivatives markets – RiskManagement, Speculation, and Investment Portfolio Diversification– in a way that hedge fund traders, consultants, and energymarket participants can apply in their day to day tradingactivities. 

  • Moving from the fundamentals ofenergy markets through simple and complex derivatives trading,hedging strategies, and industry-specific case studies, Dr. Mackwalks readers through energy trading and risk management conceptsat an instructive pace, supporting her explanations with real-worldexamples, illustrations, charts, and precise definitions ofimportant and often-misunderstood terms.
  • From stochastic pricing modelsfor exotic derivatives, to modern portfolio theory (MPT), energyportfolio management (EPM), to case studies dealing specificallywith risk management challenges unique to wind and hydro-electricpower, the bookguides readers through the complex world of energytrading and risk management to help investors, executives, andenergy professionals ensure profitability and optimal riskmitigation in every market climate.

Energy Trading and RiskManagement is a great resource to help grapple with the veryinteresting but oftentimes complex issues that arise in energytrading and risk management.

Product Details

ISBN-13: 9781118339336
Publisher: Wiley
Publication date: 06/09/2014
Pages: 320
Sales rank: 856,233
Product dimensions: 6.00(w) x 9.10(h) x 1.20(d)

About the Author

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.
To learn more about Iris and her website, please visit

Table of Contents

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 andLimitations 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 Options45

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 PowerMarkets 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 Disaster109

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 andLimitations 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 Derivatives127

6.1 Hedging with Futures Contracts 129

6.1.1 Case Studies and Examples: Hedging with Futures Contracts130

6.1.2 Risks Associated with Hedging with Futures Contracts138

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 toHedge 144

6.3.3 Example: How End Users Utilize Options on Futures to Hedge145

6.3.4 Example: How Power Marketers Use Options on Futures toHedge 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 ProtectMargin 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 ofGas-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 Caseof a New Subsidies Regime for Renewables 207

9.1 Renewable Energy, Options Pricing, and Government Subsidies209

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 ElectricityMarket 213

9.2 Government Subsidies as a Stochastic Process 216

9.3 Impact of Embedded Options and Stochastic Subsidies onPricing and Risk Management 219

9.3.1 Pricing of a Wind Turbine and Subsidies as an EmbeddedOption 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 BehavioralFinance 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 Northwest235

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

What People are Saying About This

From the Publisher

In the challenging world of energy trading, fortune favours the prepared. Whether one is brave enough (or not) comes second and not having a clear strategy would be borderline foolishness. Given such a backdrop, almost inevitably, there are resources aplenty targeting those who feel the need to be better informed and equipped. Among the latest reference sources, industry veteran and academic Dr Iris Marie Mack’s book Energy Trading and Risk Management published by Wiley is a pretty compelling one.

I instantly warmed up to the book barely a chapter in, struck by its practical approach, balanced tone, contextualised narrative and a genuine desire on the author’s part to define terms and methodologies for the benefit of those with a mid-tier investment knowledge base.

Furthermore, the instructive narrative seeks to bring about a holistic understanding of how energy markets work to begin with, leading on to an adequate treatment of risk, speculation and portfolio diversity tenets. The format in which 'Energy Trading and Risk Management' is minutely sub-sectioned point to point is simply splendid. So should you wish to salami slice and pick up bits of the subject, it would serve you just as well as a cover to cover read through.

Conversely, if you are confident enough to skip the basics and go straight through to concepts and formulas, the sequential flow of text in each chapter helps you breeze through basic definitions usually quoted in boxed text on to what you are after.

Accompanying the text are charts, case studies, background briefs, notes on macro drivers and definitions at various points split into ten weighty sub-sectioned chapters in a book of around 270 pages. From contango to the modern portfolio theory, from risk management in the renewables business to mitigation in an ever changing market climate – it’s all there and duly referenced.

While I appreciated Dr Mack's work in its entirety, a chapter on exotic energy derivatives (which follows a passage on the plain vanilla variety) stood out for me. One would be happy to recommend this title to energy professionals, fellow energy analysts and those with a desire to pursue energy trading as a career pathway.

It would most definitely appeal to entrants finding their feet in the market as well as established participants wanting to refresh their thinking and methodologies. Ultimately, for every reader this title is bound to morph from being an informative and educational book at the point of first reading, to an invaluable reference source as and when subsequently needed. That makes it worthy of any energy sector professional’s bookshelf.—Gaurav Sharma

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