Managing Energy Risk An Integrated View on

Mathematical techniques for trading and risk management.Managing Energy Risk closes the gap between modern techniques from financial mathematics and the practical implementation for trading and risk management. It takes a multi-commodity approach that covers the mutual influences of the markets for fuels, emission certificates, and power. It includes many practical examples and covers methods from financial mathematics as well as economics and energy-related models.

Markus Burger is Head of Risk Control at EnBW Trading GmbH, the trading unit of the third largest energy supply company in Germany. He leads the market risk measurement ream with responsibility for valuation and stochastic modelling as well as credit risk management. Previously, he was a analyst for interest rate derivatives at Landesbank Baden-Wurttemberg (LBBW). He holds a Masters degree and a PhD in mathematics from the University of Karlsruhe, Germany. His practical involvement and research includes stochastic modeling, risk measurement and valuation in the energy sector.

Bernhard Graeber is Head of Methodology and Models at EnBW Trading GmbH. His department is responsible for the development of load forecasting algorithms, of power plant dispatch models and of fundamental market models for electricity, CO2 certificates and fuels. He studies mechanical engineering and physics at the University of Stuttgart, Germany and at the University of Auckland, New Zealand and holds a PhD in energy economics from the University of Stuttgart. he has more that 10 years of experience in electricity market analysis and modeling.

Gero Schindlmayr is Head of Market Risk and Valuation Models at EnBW Trading GmbH. before joining EnBW he worked as a quantitative analyst for equity derivatives at Deutsche Bank A.G. He holds a PhD in mathematics and a Master's degree in operations research from the RWTH Aachen, Germany and an M.Sc degree in mathematics from Warwick University, UK. He is co-author of a book titled Equity Derivatives: Theory and Applications and of several papers in the area of energy derivatives and energy risk. His main field of work includes stochastic pricing models for electricity and gas, commodity forward curve modeling, value-at-risk models and multi-commodity risk.

Foreword	p. xi
Preface	p. xiii
Energy Markets	p. 1
The oil market	p. 4
Consumption, production and reserves	p. 4
Crude oil trading	p. 7
Refined oil products	p. 8
The natural gas market	p. 9
Consumption, production and reserves	p. 10
Natural gas trading	p. 12
Price formulas with oil indexation	p. 14
Liquefied natural gas	p. 15
The coal market	p. 16
Consumption, production and reserves	p. 17
Coal trading	p. 18
Freight	p. 22
Coal subsidies in Germany: BAFA-indexed prices	p. 23
The electricity market	p. 23
Consumption and production	p. 23
Electricity trading	p. 27
Products in the electricity markets	p. 28
Energy exchanges	p. 33
The emissions market	p. 37
Kyoto Protocol	p. 37
EU emissions trading scheme	p. 39
Flexible mechanisms	p. 42
Products and market places	p. 44
Emissions trading in North America	p. 46
Energy Derivatives	p. 47
Forwards, futures and swaps	p. 48
Forward contracts	p. 48
Futures contracts	p. 51
Swaps	p. 52
"Plain vanilla" options	p. 53
The put-call parity and option strategies	p. 53
Black's futures price model	p. 55
Option pricing formulas	p. 55
Hedging options: the "Greeks"	p. 57
Implied volatilities and the "volatility smile"	p. 62
Swaptions	p. 64
American and Asian options	p. 66
American options	p. 66
Asian options	p. 66
Commodity bonds and loans	p. 69
Multi-underlying options	p. 69
Basket options	p. 70
Spread options	p. 72
Quanto and composite options	p. 73
Spot price options	p. 76
Pricing spot price options	p. 77
Caps and floors	p. 78
Swing options	p. 80
Virtual storage	p. 83
Commodity Price Models	p. 87
Forward curves and the market price of risk	p. 88
Investment assets	p. 89
Consumption assets and convenience yield	p. 89
Contango, backwardation and seasonality	p. 91
The market price of risk	p. 91
Derivatives pricing and the risk-neutral measure	p. 92
Commodity spot price models	p. 95
Geometric Brownian motion	p. 95
The one-factor Schwartz model	p. 100
The Schwartz-Smith model	p. 103
Stochastic forward curve models	p. 108
One-factor forward curve models	p. 109
A two-factor forward curve model	p. 111
A multi-factor exponential model	p. 112
Electricity price models	p. 113
The hourly forward curve	p. 114
The SMaPS model	p. 117
Regime-switching model	p. 120
Multi-commodity models	p. 125
Regression analysis	p. 125
Correlation analysis	p. 128
Cointegration	p. 128
Model building	p. 130
Fundamental Market Models	p. 131
Fundamental price drivers in electricity markets	p. 132
Demand side	p. 132
Supply side	p. 136
Interconnections	p. 143
Economic power plant dispatch	p. 143
Thermal power plants	p. 145
Hydro power plants	p. 151
Optimisation methods	p. 155
Methodological approaches	p. 166
Merit order curve	p. 166
Optimisation models	p. 178
System dynamics	p. 184
Game theory	p. 186
Relevant system information for electricity market modelling	p. 196
Demand side	p. 196
Supply side	p. 197
Transmission system	p. 200
Historical data for backtesting	p. 201
Information sources	p. 201
Application of electricity market models	p. 202
Gas market models	p. 204
Demand side	p. 205
Supply side	p. 206
Transport	p. 208
Storage	p. 210
Portfolio optimisation	p. 212
Formulation of the market model	p. 212
Application of gas market models	p. 215
Market models for oil, coal, and CO[subscript 2] markets	p. 215
Electricity Retail Products	p. 217
Interaction of wholesale and retail markets	p. 217
Retail products	p. 220
Common full service contracts	p. 220
Indexed contracts	p. 221
Partial delivery contracts	p. 222
Portfolio management	p. 223
Supplementary products	p. 224
Sourcing	p. 225
Business-to-business (B2B)	p. 226
Business-to-consumer (B2C)	p. 227
Small accounts	p. 227
Municipalities and reseller	p. 228
Load forecasting	p. 228
Risk premium	p. 230
Price validity period	p. 231
Balancing power	p. 232
Credit risk	p. 235
Price-volume correlation	p. 235
Strict risk premiums	p. 237
Hourly price profile risk	p. 239
Volume risk	p. 240
Operational risk	p. 240
Risk premium summary	p. 241
Risk Management	p. 243
Market price exposure	p. 243
Delta position	p. 244
Variance minimising hedging	p. 249
Value-at-Risk and further risk measures	p. 250
Definition of Value-at-Risk	p. 250
Parameters of the Value-at-Risk measure	p. 252
Computation methods	p. 253
Liquidity-adjusted Value-at-Risk	p. 258
Estimating volatilities and correlations	p. 261
Backtesting	p. 263
Further risk measures	p. 264
Credit risk	p. 265
Legal risk	p. 266
Quantifying credit risk	p. 267
Credit rating	p. 269
Appendices	p. 275
Mathematical background	p. 275
Econometric methods	p. 275
Linear regression	p. 275
Stationary time series and unit root tests	p. 277
Principal component analysis	p. 279
Kalman filtering method	p. 279
Regime-switching models	p. 281
Stochastic processes	p. 283
Conditional expectation and martingales	p. 284
Brownian motion	p. 284
Stochastic integration and Ito's lemma	p. 285
The Feynman-Kac theorem	p. 287
Monte Carlo simulation	p. 288
Bibliography	p. 291
Index	p. 295
Table of Contents provided by Ingram. All Rights Reserved.

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Managing Energy Risk An Integrated View on Power and Other Energy Markets

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Author Biography

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