9 - Correlation
Published online by Cambridge University Press: 05 June 2014
Summary
Up to this point, our focus has been on single-commodity options structures. These are commonly used by producers and consumers to hedge their natural positions, as well as by speculators or investors desiring levered exposure in some form. As a general rule across asset classes, however, options markets of meaningful depth usually result from “natural” sources of optionality. Mortgages provide the best and certainly the largest example. Typical home mortgages have embedded prepayment options that are a major reason for the existence of closely related interest-rate swaptions markets. For energy markets, it is infrastructure, essential to the basic balancing of supply and demand, that is the natural source of “steel in the ground” optionality.
A power generator is, to a first approximation, an option to convert a fuel to electricity – a call option on the spread between the input and output commodity prices. A natural gas pipeline connecting one delivery point to another is an option on the spread between two locational prices. A natural gas storage facility, as we will see later, is a complex structure that can loosely be thought of as a combination of options on the spread between forward prices with different delivery times.
Spread options are by far the dominant natural source of optionality in energy markets. It is in the valuation and hedging of spread options that correlation risk first arises. The methods commonly used to value spread options are discussed in standard references [Hul12, Shr04], although the very high correlations that usually arise in energy spread options raise issues that are not typically encountered in other contexts, such as equities basket options.
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- Valuation and Risk Management in Energy Markets , pp. 187 - 220Publisher: Cambridge University PressPrint publication year: 2014