II - Basic Valuation and Hedging
Published online by Cambridge University Press: 05 June 2014
Summary
All markets have limitations in the instruments that can be efficiently traded. The broader the set of liquid tradable instruments in a market, the more effectively risks embedded in exotic structured trades can be hedged. As the collection of available price data expands, calibration of valuation models becomes less dependent on statistical estimation of unhedgeable parameters, reducing modeling risk. In most markets, concerns about market depth and liquidity revolve primarily around the options available for model calibration. In energy markets challenges arise at the much more basic level of swaps and forwards.
We saw in Part I that energy is produced and consumed at many physical locations. However, swaps liquidity is typically limited to a few benchmarks such as West Texas Intermediate (WTI) and Brent for crude oil, Henry Hub or National Balancing Point (NBP) for natural gas, and PJM Western Hub for U.S. power. The result is that many energy portfolios have risks of very high dimensionality, while portfolio managers have relatively few hedging instruments at their disposal. Successfully navigating the challenges of such portfolios depends greatly on analysis of forward dynamics and sensible application of the results.
The situation is even more severe in the energy options markets, where liquidity is typically concentrated at even fewer benchmarks and at shorter tenors. To compound matters, the types of options that are traded shed relatively little light on the term structure of volatility for any given forward price, which results in exposure to modeling risk in situations that would, in most other markets, be viewed as quite routine.
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- Valuation and Risk Management in Energy Markets , pp. 79 - 80Publisher: Cambridge University PressPrint publication year: 2014