Introduction Derivatives

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Introduction Derivatives

• Your Commodities Risk Management Partner
• Benefit from 20 years of experience in the
  commodity industry
• Kasper Walet
• walet_at_maycroft.com

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Kasper Walet

• 20 Years of commodity exchange experience
• Former Board Member of the Amsterdam Commodity
  Futures Exchange and Clearing House (1987-1997)
• Founder of Maycroft in 1997

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Maycroft

• Strategic Consulting and Training
• Energy Commodities and Risk Management
• Oil,Power, Gas, Coal,Weather,Emissions
• Active on global level
• Key Benefits
• 20 years of experience in commodity industry
• in-depth knowledge of global carbon markets and
  emissions trading
• 'best practice' solutions for your specific
  situation

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Risk Management Assessment Maycroft Risk
Reviewer

• Main lesson from current financial crisis is that
  risk management is absolutely fundamental for the
  survival of every organization
• So now is the time to make a thorough analysis of
  your current risk management framework
• Strengthen your risk management
• Bring it up to the best practice standards within
  the industry
• Maycroft is an independent expert company that
  can do this assessment for you

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Forward Curve Creator

• With our Forward Creator you can create
  up-to-date forward hourly price curves yourself,
  without having to employ expensive modeling
  experts.
• Our model is specifically suitable for every
  electricity supplier or trader, big or small, who
  delivers or deals with non-standard electricity
  contracts with variable (not only base-load and
  peak-load) delivery schedules.
• Free 4 week Trial

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Contract Markets

• Formal contracts covering future delivery of
  energy
• Form the basis for long-term price curves which
  support investment decision making
• Allow market participants to achieve certainty of
  cash flow
• Contracts can be bilateral (between market
  participants) or traded through an exchange
• Contracts can involve physical delivery or
  involve financial settlement

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Futures
OTC Options
Spot Market
Forwards
Swaps
Options
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Derivative Contracts

• All financial contracts are derivative contracts
• Can involve a degree of optionality e.g options,
  caps, floors
• Could be combination of spot and/ or published
  forward/ contract prices
• May involve more than one price index (e.g.
  interregional) , or even more than one
  commodity (e.g. spark spread option).
• Difficult to value
• as published forward curves do not really
  represent the types of prices covered by
  contracts

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History

• Derivatives used for ages
• Example Tulip-mania 17th century
• First option exchange CBOE 1973
• Black-Scholes formula 1973
• Nobel prize for Scholes and Merton 1997
• Bankruptcy hedge-fund LTCM 1998

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Common Derivatives

• Futures
• Exchange traded
• Essentially financial
• Forwards
• Over the counter (OTC)
• Physicals
• Swaps
• OTC
• Financials
• Options
• Exchange traded or OTC
• Physical or financial

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Forwards

• Obligation to buy or sell a fixed amount of
  electricity at a pre-specified contract price(the
  forward price), at certain time in the future
  (called maturity or expiration time).
• Electricity forwards are custom tailored supply
  contracts between a buyer and a seller,
• Buyer is obligated to take power
• Seller is obligated to supply

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Prices forwards

• Electricity forward prices
• Based on forward (long-term) expectations
• Stable behavior
• Long-term forwards have low volatility,
  short-term forwards may have high volatility
• Correlation with fuels

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Example gas fired generation
Market scenario variable higher profit, higher
risk in normal operation, reduced exposure to
outage Buy gas forward, sell spot gas buy spot
power, sell power forward
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Example Processing
Process scenario - fixed low profit, low risk Buy
power forward, produce commodity, sell commodity
forward lock-in a profit
Cost Buy Power Revenue Sell Commodity Profit
300,000 360,000 60,000
Commodity Forward sales contract 30/MWh
Processing consumes 12,000 MWh per day
Power Forward purchase contract 25/MWh
Cut Process scenario variable higher profit,
higher risk (spot price) Buy power forward, sell
spot power buy spot commodity, sell commodity
forward
Cost Buy Power Buy Spot Commodity Revenue Sell
Commodity Sell Spot Power Profit
300,000 480,000 360,000
900,000 480,000

Commodity Forward sales contract 30/MWh
No Processing
Power Forward purchase contract 25/MWh

Buy Spot Commodity 40/MWh
Sell Spot Power 75/MWh


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Futures

• Same payoff structure as Forwards
• Futures contracts highly standardized
• Contract specifications,
• Trading locations,
• Transaction requirements,
• Settlement procedures.
• Main difference between Futures and Forwards is
  the quantity of power to be delivered.
• Delivery quantity specified in electricity
  futures contracts is often significantly smaller
  than that in forward contracts.

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Futures

• Futures traded on organized exchanges
• Forwards are usually traded OTC
• as bilateral transactions.
• Making futures prices more reflective of higher
  market consensus and transparency than forward
  prices.
• Majority of electricity futures contracts are
  settled by financial payments (cash settlement)
  rather than physical delivery, which lower the
  transaction costs.

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Futures

• Credit risks and monitoring costs futures much
  lower than for forwards
• Exchanges strict margin requirements
• OTC transactions are vulnerable to financial
  non-performance due to counterparty defaults.
• Futures lower credit risk
• Gains and losses of futures are paid out daily
• Forwards are cumulated and paid out in a lump sum
  at maturity time

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PL Short Future
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Futures Short Hedge
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Hedging with Futures Cash Flows
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Pros and Cons Futures

• Pros
• Market consensus
• Price transparency
• Trading liquidity,
• Reduced transaction and monitoring costs
• Cons
• Various basis risks due to rigid specs
• Limited transaction quantities specified in the
  contracts.

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Swaps

• Financial contracts
• Holders pays fixed price for electricity,
  regardless of floating electricity price, or vice
  versa, over the contracted time period.
• Established for fixed quantity of power
  referenced to a variable spot price at either a
  generators or a consumers location.
• For short- to medium-term price certainty up to a
  couple of years.
• Strip of electricity forwards with multiple
  settlement dates and identical forward price for
  each settlement.

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Example Fixed for Floating Swap
Generator pays
Swap price
Bank pays
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Example electricity swap

• Imagine it is November 2009 and a generator
  enters into a contract to sell 50 MW of
  electricity for the period of December 2009 at a
  daily floating price. The power can be generated
  at 23 /MWh
• What is the market risk?

Physical power
Buyer
Generator
Floating price
25
Supply unhedged

• Basis APX baseload
• Volume 50 MW
• Period 01/12/09 - 31/12/09 ( 31 days )
• Fixed Price None
• Floating Price ???
• Prod. costs 23 Euro

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Example electricity swap

• Bank agrees to pay Generator 25/MWh for 50 MW
  of power during December 2009.
• Generator agrees to pay Bank cash flows equal to
  a floating price on the same quantity of
  electricity for one year.
• By combining this swap with the indexed
  electricity supply contract, a Generator can lock
  in a fixed income and sell to APX

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Cash flows hedged
Floating Price
Floating Price
Buyer
Generator
Trader
Fixed Price
Fixed Cost
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Supply hedged

• Basis APX baseload
• Volume 50MW
• Period 01/12/09 - 31/12/09
• Fixed Price 25 /MWh
• Prod. Costs 23 /MWh
• Floating Price 21 (December 09 average)

IN OUT
21 (deliver) 25 (swap)
21 (swap) 23 (costs)
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Options

• Not new!
• Optionality needed to react to fluctuations in
  consumption, transmission interruption or plant
  outages
• Power plants or gas storage provided flexibility
  to balance system
• Now optimise profit against market prices
• Many options on daily or hourly basis can be seen
  as type of power plant
• Virtual power plant

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Option works like Insurance contract


Seller of Option is the insurer Risk is added to
the portfolio Collects premium
Buyer of Option is the insured Risk is removed
from the portfolio Pays premium
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Options

• Buyer has the right but not the obligation to buy
  or sell the asset at the previously agreed price.
  
• Seller has the obligation to deliver or take.
• Similar to insurance
• buyer pays premium every year
• insurance pays any damages

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Standard Options

• Call gives the option holder the right to buy at
  a predetermined price
• Put gives the holder the right to sell at a
  predetermined price
• European, American and Asian style

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Components of Option Price/ Premium
Strike price
Pr. Underlying
Premium
Time to expiry
Pricing model
Interest rate
Volatility
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Strike Price

• Strike price
• price for which underlying commodity can be
  bought or sold
• Value option contract is relative to strike price
• Option contract can be
• At the Money (ATM)
• In-the Money (ITM)
• Out-of-the Money (OTM)

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(No Transcript)
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Long call (buy call)
Strike price 50
Profit
Price underlying
50
40
Break-even-point 50 10 60
-10
Loss
Maximum loss premium 10
Unlimited upward potential Losses limited to
premium
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Pay-off diagram put purchase
profit loss
underlying
Exercise price

• Price lt strike profit (excluding premium)
• Price gt strike loss equal to premium
• Unlimited upward potential
• Losses limited to premium

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Implied Volatility

• Nearer months have higher volatility
• Seasonal effects also contribute to volatility
• Reasons
• Nearby months more heavily traded.
• More knowledge about positions
• Balancing supply and demand
• More fundamental information about
• Supply, demand, transportation and weather etc.
• Seasonal demand leads to seasonal volatility
• Fear factor higher volatilities at times of
  greater uncertainty in market prices

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Option types?

• Derivatives and Options
• Right to purchase at fixed price (call)
• Right to sell at fixed price (put)
• European Vs American
• Swing options (variable quantities)
• Interruption/Curtailment options
• Capacity/Energy compound options

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Asian Option

• Pay off does not depend on single price at expiry
• On average of realised prices over some time
  period
• Look back at past and pay out on basis realised
  prices Look back or Path dependent options

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Pros and Cons Options

• Advantages
• limited risk
• unlimited profit opportunities
• very flexible
• Disadvantages
• premium payment
• therefore high cost

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Options as a Hedge

• Protection against downside price movements
• So not necessarily downward
• Consumer of electricity, physical supply contract
  based on floating market prices
• Concern?
• Consumer Hedge European Call

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Cap

• Definition
• Agreement between two parties in which the buyer
  of a floating electricity price is granted a
  maximum.
• Buyer pays a premium that guarantees him that
  whenever the reference price exceeds the cap, he
  will be compensated

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Electricity costs with a cap
Electricity costs

Not hedged
50
hedged
40
Cap-strike
10
Market price
40
30
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Electricity costs floor
Electricity costs floor

unhedged
hedged
30
Floor-price
23
Market price
37
30
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Cost of Hedging with Options

• What can hedger do if he feels option premium too
  expensive?
• Change option strike price
• Do not hedge full physical volume

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Costless Collar

• Combination of a cap and a floor, in which the
  exercise price of the cap lies above that of the
  floor. The buyer of a collar buys a cap and sells
  a floor

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Electricity costs collar
Electricity costs

unhedged
43 40
hedged
cap-price
33 30
floor-price
Market price
40
30
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Derivatives Packages

• Receive tailored solution to risk management
  needs
• Minimizing premium by sacrificing upside
  potential
• Benefit from view on the market movement
• Build in flexibility

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Spark Spread Options

• Cross-commodity options
• Paying out the difference between the price of
  electricity sold by generators and the price of
  the fuels used to generate it.
• The amount of fuel that a generation asset
  requires to produce one unit of electricity
  depends on the asset's fuel efficiency or heat
  rate.

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Swing Options

• May be exercised daily or up to a limited number
  of days during the period in which exercise is
  allowed.
• When exercising the daily quantity may vary
  between a minimum daily volume and a maximum
  volume.
• However, the total quantity taken during a time
  period such as a week or a month needs to be
  within certain minimum and maximum volume levels.

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Swing Options

• Strike price either fixed throughout its life or
  set at the beginning of each time period based on
  some pre-specified formula.
• If the minimum-take quantity of any contract
  period is missed by the buyer, then a lump sum
  penalty or a payment making up the sellers
  revenue shortfall needs to be paid (i.e.,
  take-or-pay).

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Trading in Power Markets

• Asset, commercial or industrial optimization
• Balancing real time needs
• Buying additional supply or selling excess
  production
• Optimal choice of feedstock
• Hedging
• Reducing riskiness of portfolio
• Speculation
• Investment
• Arbitrage

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Derivatives and managing risks

• Reduce earning volatility
• Investors/Capital Markets may desire predicable
  future earnings
• May be achieved by locking-in both the purchase
  and sales price of a product, regardless of
  future price movements
• Manage other risks
• Basis risk (locational)
• Credit risk
• Operational risk (physical delivery, plant
  outages)

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Hedging in the 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

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Cross Commodity Arbitrage

• Energy intensive industrial company
• Buy from market or buy gas for on site generation
• Large new order meaning production up in 3
  months from now
• Extra demand 4,000 MWh peak load
• Power Forward market 60/MWh
• Gas Forward market 58/MWh
• What will they do and what happens to market
  price?

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Cross Commodity Arbitrage

• Buy gas forward
• Save 2 /MWh x 4,000 MWH 8,000
• Purchase put upward pressure on forward price gas
• Closing the gap between gas and power forward
  prices

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Sources of derivative value movement

• Changes in spot market rates
• Changes in forward market rates over entire
  duration (tenor) of the instrument
• Unusual terms (combined derivatives leverage
  factors)
• Additional market factors (volatilities,
  correlations, spreads)
• Changes in creditworthiness of one or both
  counterparties
• collateral and master netting arrangements to
  offset derivative assets and liabilities between
  the same two counterparties

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Forward Curve

• Markets view of prices for future delivery that
  can be locked in today
• Spot electricity today is a different asset from
  the spot electricity in the future.
• Demand (supply) today does not necessarily have
  anything to do with the demand (supply) in the
  future

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Forward Curve

• Electricity forward curve exhibits
• Seasonality
• Over 1 day (Time of use)
• Over 1 week (Non working days)
• Over 1 year (Seasonality)
• Extreme volatility at the short end