Managing energy risk a nontechnical guide to markets and trading

wengler fm pp00x-xii 10/16/02 1:16 PM Page i managing energy risk: a nontechnical guide to markets and trading wengler fm pp00x-xii 10/16/02 1:16 PM Page ii wengler fm pp00x-xii 10/16/02 1:16 PM Page iii managing energy risk: a nontechnical guide to markets and trading by john wengler wengler fm pp00x-xii 10/16/02 1:16 PM Page iv Copyright © 2001 by PennWell Publishing Company 1421 South Sheridan Road Post Office Box 1260 Tulsa, Oklahoma 74101 1-800-752-9764 sales@pennwell.com www.pennwell.com www.pennwell-store.com Cover design and book layout by Joey Zielazinski ISBN 0-87814-794-2 All rights reserved No part of this book may be reproduced, stored in a retrieval system, or transcribed in any form or by any means, electronic or mechanical, including photocopying and recording, without the prior written permission of the publisher Printed in the United States of America 05 04 03 02 01 wengler fm pp00x-xii 10/16/02 1:16 PM Page v dedication To Dragana, my love wengler fm pp00x-xii 10/16/02 1:16 PM Page vi wengler fm pp00x-xii 10/16/02 1:16 PM Page vii Contents List of Figures and Tables ix Acknowledgements xii Foreword by Jeffrey Roark, Southern Energy xiv Editor’s Note by Dragana Pilipovic, SAVA xix Introduction: The “Top Ten Checklist” of Things to Do The Bull, the Bear, and the Spark Spread 19 The Risk Management Policies and Procedures 47 Starting with Your Risk-Return Strategy 71 The Risk Roster: Personalities and Specialties 89 Energy Risk Boot Camp: “Must Know” Concepts for Managers and Directors .103 The Deal Process: From the Desk to Delivery 145 The Portfolio Process: Starting with What Have We Got? and What Do We Want? 165 Measuring Risk: How Might Our Portfolio Change? 203 10 Hedging: Navigating Toward Our Portfolio Objectives 233 11 Critical Path IT Issues .255 12 Looking Forward: The Next Ten Management Issues 267 Appendix Items to Consider for Trading and Derivatives Policies, Guidelines, Controls, and Internal Procedures by Andrea S Kramer, McDermott, Will & Emery 281 vii wengler fm pp00x-xii 10/16/02 1:16 PM Page viii Managing Energy Risk: A Nontechnical Guide to Markets and Trading Glossary 321 Bibliography .369 Index 373 viii wengler fm pp00x-xii 10/16/02 1:16 PM Page ix List of Figures Figures Figure 1-1: Figure 2-1: Figure 2-2: Figure 3-1: Figure 5-1: Figure 6-1: Figure 6-2: Figure 6-3: Figure 6-4: Figure 6-5: Figure 6-6: Figure 6-7: Figure 7-1: Figure 8-1: Figure 8-2: Figure 8-3: Figure 8-4: Figure 8-5: Figure 8-6: Figure 8-7: Figure 8-8: Figure 8-9: Figure 8-10: Figure 8-11: Figure 8-12: Figure 8-13: Figure 8-14: Figure 8-15: Figure 8-16: Figure 9-1: Figure 9-2: Figure 9-3: Java Moments by Chapter 16 What Makes an Efficient Market? 24 Dynamic Structure of a Market 24 The U.S Constitution as Symbol of RMPP 49 Concentric Circles Model 95 The Price-Risk Pyramid 110 Price-Mean Reverting Distribution 115 Cinergy 5x16 Daily Forward Price Curve .115 Entergy 5x16 Daily Forward Price Curve .116 NYMEX Natural Gas Daily Forward Price Curve 116 The Model Calibration Process 120 Volatility Term Structure 123 Overview of Deal Cycle 147 The Hedging Cycle 167 Simple Payoff Diagram 170 Delta on Payoff Diagram 175 Short Forward Position 176 Probabilities of Outcome .177 Long Call Option Payoff 181 Profit Diagram for Call 182 Parity Value of a Call Option 183 Four Mirror Images 185 A Long and Short Forward 187 Synthetic Call Option 188 Load Curtailment Contract 189 Two Long Call Options 190 Generator’s Initial Portfolio 191 A Dream Profit Diagram 199 Profit Diagram by Risk Return Strategies .200 Different Risk Measures 212 Sample Risk Profiles .214 Sample Delta Values .216 ix wengler new index pp373-390 10/16/02 2:08 PM Page 377 Index Deal process, 63, 145-163, 198, 257, 317: operations, 63; manager’s viewpoint, 145-153, 156-163; negotiating the deal, 153-156; approval, 156-157; book assignment, 156-157; capture, 156-157, 198, 257; endnotes, 163; input/ edits/audits, 317 Deep-in-the-money, 131, 219 Deep-out-of-the-money, 217 Defining the portfolio (RMPP), 167169: generation assets, 168-169; treating assets as options, 169; retail positions, 169; transmission assets/aspects, 169; other traded markets, 169 Definitions, 321-368 Delivery rules (settlement), 160-161 Delivery specifications (settlement), 160-162: rules, 160-162 Director of Information Technology, 100-101 Disclosure obligations, 320 Diversification effect, 127 Documentation, 309-311, 318 E E-commerce trend, 242-243 Efficient market, 20-28, 44, 112: asset, 21-24; region, 23, 25; standardized contracts, 25; forward strips, 25; liquidity, 26; price discovery, 26-27; central meeting place, 28 Electric power market, 28-32, 93, 243: characteristics, 29-31; price inelasticity, 30-31; volumetric risk, 31-32; liquidity factors, 243 Delta and gamma (payoff and profit diagrams), 215-220: delta change, 215-217; risk sensitivities, 217219; price risk during price spike, 220 Emerging markets, 91-94, 276: leadership, 91-92; risk managers, 91-94; traders, 92-93; cultural differences, 93; identification, 94 Delta change, 193-194, 215-220: diagrams, 215-220 End-of-day analysis, 67 Demand side management, 189 Deregulation, 19-20, 34-39, 78-80, 86, 92: marking to market, 37-39 Derivatives, 22-23, 84-86, 91-92, 107109, 281-320: hedging, 107-109; policies, 281-320 Desired portfolio, 66-67, 233-234 Employee requirements, 289-293 Energy risk management/concepts, 34, 53-59, 103-143: trading and derivatives policies, 53-59; overview, 103-106; derivatives and hedging, 107-109; price-risk pyramid, 109-139; endnotes, 140143 Energy risk overview, 103-106: marking-to-market concept, 104; market prices drive analysis, 104; 377 wengler new index pp373-390 10/16/02 2:08 PM Page 378 Managing Energy Risk: A Nontechnical Guide to Markets and Trading forward price behavior, 104; volatilities, 104-105; correlations, 105; options, 105; risk management, 105-106 Energy trading and derivatives policies, 53-59: Board responsibilities, 54; Risk Management Committee, 54-55; Risk Manager, 55; traders, 55-57; risk exposure, 57; legal review, 57; accounting and tax, 58; internal controls, 58-59 Enforcement, 63-64, 226-228: RMPP, 63-64; risk limits, 226-228 Financial Accounting Standard 133, 43, 241, 269: hedging accounting rules, 241 Financial Accounting Standards Board (FASB), 43 Financial analysis, 76-77 Fixed-rate contracts, 241-242 Floors (option), 135 Forward contract, 114, 117-118, 129 Forward position, 172-178 European options, 134 Forward price behavior, 104, 114-120: quantitative vs fundamental modeling, 117; curve, 115-120; models, 119-120 Execution (deal), 155 Forward price curve, 115-120 Executive reporting (profits and losses), 192 Forward price models, 117, 119-120: calibration, 119-120 Exempt wholesale generator (EWG), 34 Forward price, 104, 112-120: behavior, 104, 114-120; curve, 115-120; models, 117, 119-120 Engineering professionals, 36-37 Exercise type (contract), 152 Expiration date rules (settlement), 158-160 Exposure/hedging strategy, 259-261: niche specialists, 260; high school kids, 260; build vs buy, 260-261 F Facilitator duties, 90 Far-in-the-money, 131 Federal Energy Regulatory Commission, 34 378 Forward strips, 25 Front/middle/back office model, 9697 Full requirements contract, 134 Fundamental/structural modeling, 4041, 117 Future management issues, 267-279: checklist, 267-268; Federal Accounting Standard 133, 269; building liquidity, 269-270; risk of reregulation, 270; reliability risk, 270-274; risk of savings and loan-type crisis, 274-275; power industry portfolios, 275; portfolio management approach, 275-276; wengler new index pp373-390 10/16/02 2:08 PM Page 379 Index new markets, 276; old business, 276-277; information technology, 277; leadership, 277-278; endnotes, 278-279 procedures, 307-314; customer appropriateness evaluation, 314316; training programs, 317; back office policies and procedures, 317-320; disclosure obligations, 320 Futures contract, 128 G Gamma change, 193-194, 215-220 Gamma criterion, 203-206: risk variables, 204-206 Gamma diagrams, 215-220 Generation assets, 168-169 Generator’s initial portfolio, 191, 197201: prices drop below cost, 197; optimal operating range, 197; prices spike/short capacity, 197; capturing initial portfolio in RMPP, 198; sample profit objectives (risk-return strategy), 198200; articulating objectives in RMPP, 201 Gladiator, 90 Glossary, 321-368: abbreviations and notations, 321-324; terms/definitions, 325-368 Governance issues, 62, 67 Greek analysis, 136-138, 246: hedging, 246 Guidelines/controls/internal procedures, 281-320: outline, 281-285; risk management policy, 286-298; trading policies, 298-307; credit policies and risk management H Hedging (portfolio objectives), 233253: desired portfolio, 233-234; strategy defines hedging objectives, 234-238; hedging on sea of trading liquidity, 238-243; quality contracts, 244; hedging analysis, 244-247; case study, 247-249; case study (lower cost), 249-252; portfolio objectives achievement, 251, 253; endnotes, 253 Hedging accounting rules, 241 Hedging analysis, 65, 136, 244-247: plug and chug, 246; Greek matching, 246; minimum variance analysis, 246-247 Hedging cycle, 165-167, 233-238 Hedging horizon, 151-152 Hedging on market liquidity, 238-243: hedging definition, 238; market liquidity, 238-239; NYMEX Henry Hub basis phenomenon, 239; brokers, 239-240; liquidity change in 1990s, 240; price risk, 240; positions, 240-241; FAS 133 accounting rules, 241; speculative positions, 241; strategy, 241; fixed-rate contracts, 241-242; 379 wengler new index pp373-390 10/16/02 2:08 PM Page 380 Managing Energy Risk: A Nontechnical Guide to Markets and Trading options, 241-242; holding options, 242; e-commerce trend, 242-243; liquidity factors in power market, 243 Hedging strategy, 234-238, 241 Hedging, 65, 107-109, 113, 136, 151152, 165-167, 233-253: analysis, 65, 136, 244-247; continuous, 113; horizon, 151-152; cycle, 165-167, 233-238; portfolio objectives, 233-253; strategy, 234-238, 241; market liquidity, 238-243; positions, 240-241; price risk, 240; accounting rules, 241; options, 241-242 Henry Hub, 35, 239 High risk, 214 High school kids, 260 Historical volatilities, 124-125 Holding asset vs forward contract, 114 Holding options, 242 Human risk management, 204-210: trading operation accounts, 207; accounts management, 207; risk management and trust, 207; rogue trading, 207-208; moral hazard, 207-208; management focus, 208; loss of trust, 208-209; trading perceptions, 209; management priorities, 209-210; human error, 209210 I Identification (emerging markets), 94 Independent power producer (IPP), 33-34 Information technology issues, 100101, 255-265, 277: computer systems, 255-256; trading and portfolio management system, 256258; specify needs in RMPP, 258; hiring/managing staff, 259; matching budget to strategy, 259261; build vs buy dilemma, 261263; vendors, 263-265 Information technology (RMPP), 258 Information technology staff (hiring/ managing), 259 Information technology vendors, 263265: heritage, 264-265 Informed discussion, 229-230 Initiation and negotiation (deal), 153 Integrated systems, 111 Intercompany/related party activities, 298 Internal controls, 58-59 In-the-money, 131, 219 Intra-market correlations, 126-127 J Java moment, 15-16 380 needs wengler new index pp373-390 10/16/02 2:08 PM Page 381 Index L Lawyers, 101 firmation, 157; settlement (delivery/payment), 157-162; booked/ committed deal, 163 Leadership, 91-92, 277-278 Market analysts (asset management), 98-100 Legal review, 57, 296, 306-307 Market book/portfolio, 151 Linear portfolio, 202 Market change, 16-17, 41, 171 Liquidity (market), 20, 26, 35, 238243, 269-270: hedging, 238-243; change in 1990s, 240; power market factors, 243 Market definition (portfolio), 198 Load curtailment contract, 83-84, 187190 Locational marginal pricing, 41 Long (bought) contract, 184 Long call, 184-185 Long put, 184-185 Loss of trust, 207-209 M Macro vs micro-management, 61 Management focus/priorities, 208-210 Manager’s viewpoint (deal process), 145-153, 156-163: motivation for trade, 146-148; counterparty and credit risk control, 148-150; contract types allowed, 150-151; contract specifications, 151-152; initiation and negotiation, 153; deal approval/capture/book assignment, 156-157; trading/risk system, 156-157; back office con- Market efficiency, 20-28, 44, 112 Market information, 119-122: convergence to market inputs, 119; models for forward prices, 119-120; model calibration, 119-120; twofactor variable, 120; price mean reversion, 120-121; stochastic model, 121; quantitative model, 121-122; seasonality functions, 122 Market liquidity, 238-240, 243: change in 1990s, 240; power market factors, 243 Market maker, 72-73, 79-80, 82-84, 147, 200: strategy, 72-73, 79-80, 82-84; motivation, 147; objectives, 200 Market opportunity, 77-78 Market price, 104, 256: analysis drive, 104; signal to system, 256 Market risk, 204-205 Market structure, 35 Market validation (profits and losses), 192 Market volatility, 112-113, 125 Market-driven VaR, 138-139 381 wengler new index pp373-390 10/16/02 2:08 PM Page 382 Managing Energy Risk: A Nontechnical Guide to Markets and Trading Marking-to-cost, 39 Marking-to-market concept, 5-6, 16, 37-39, 43, 83, 98-100, 104, 117, 119, 125-126, 130, 138, 148, 169, 171, 211, 215, 244, 256: applications, 38-39 Marking-to-model concept, 125-126: approximations, 126 Markov process, 44 Measurement means enforcement, 6364 Measuring risk (portfolio change), 203-231: gamma criterion, 203; risk variables, 204-206; risk management, 206-210; price risk measurement, 210-213; price risk on payoff diagram, 213-214; delta and gamma (payoff and profit diagrams), 215-220; plotting price risk by time bucket, 220-223; credit risk, 224; volumetric and transmission risk, 224-225; setting risk limits, 225-229; quantifying risk limits, 228-230; endnotes, 231 Meeting place (central), 28 Modeling (price), 117, 119-120, 130: forward prices, 119-120; real prices, 130 Modeling consistency, 111 Modeling risk, 204-205 Monitoring/updating risk limits, 228229 Monte Carlo simulations, 139 Moral hazard, 207-208 Motivation (objectives in RMPP), 201 Motivation for trade, 146-148: treasury, 146; speculation, 147; arbitrage, 147; market maker, 147; price discovery phone calls, 148 Multiple-peaker option, 134 N Near-the-money, 131, 217 Negotiating the deal, 153-156: vision, 154; preparation, 154-155; execution, 155; closure, 155-156 Minimum variance analysis (hedging), 246-247 NEPA/NEPA92, 34 Model assumptions, 113, 196 New markets, 91-94, 276: leadership, 91-92; risk managers, 91-94; traders, 92-93; cultural differences, 93; identification, 94 Model calibration, 119-120: two-factor variable, 120 Model functions (volatility analysis), 125-126 Networking, 12-13 Niche specialists, 260 Model validation (profits and losses), 192 North American Electric Reliability Council (NERC), 44 Model-implied volatility, 125 Notional aggregations, 64 382 wengler new index pp373-390 10/16/02 2:08 PM Page 383 Index NYMEX, 28, 35, 41, 158, 239 Payoff and profit diagrams, 170-178, 215-221: delta change, 215-217; risk sensitivities, 217-219; price risk/price spike, 220 O Payoff choice (options), 179-185 Old business, 276-277 Pennsylvania-Jersey-Maryland (PJM) market, 41 Operating range, 197 Performance (quantitative), 229-230 Operational risk, 196, 204, 206 Operations (trading), 298-302 Personnel personalities/specialties, 89-102 Optimal operating range, 197 Pilipovic model, 119-122 Option action types, 135 Plotting (price risk), 220-223 Option-implied volatilities, 125 Plug and chug (hedging analysis), 246 Options (value of choice), 36-37, 105, 125, 128, 130-135, 179-185: volatilities, 125; terminology, 132-133; action types, 135; caps, 135; floors, 135; straddles, 135; strangles, 135; collars, 135; payoff, 179-185 Policies (trading and derivatives), 281-320: outline, 281-285; risk management policy, 286-298; trading policies, 298-307; credit policies and risk management procedures, 307-314; customer appropriateness evaluation, 314316; training programs, 317; back office policies and procedures, 317-320; disclosure obligations, 320 Organizational structure/responsibilities, 286-288 Other traded markets, 169 Out-of-the-money, 131, 217 Over-the-counter market, 28, 41, 128 Policies and procedures (differences), 60-61: responsibility, 60-61; macro/micro management, 61; limits, 61; governance, 61 Political sponsor, 10 P Portfolio analysis, 64-67, 166: questions, 64-67 Palo Verde, AZ, 35 Portfolio desired, 66-67, 233-234 Parity value, 180, 183-184 Portfolio management, 62-67, 151, 156-157, 165-202, 220-221, 233234, 251, 253, 275-276: risks Payment rules (settlement), 160, 162 383 wengler new index pp373-390 10/16/02 2:08 PM Page 384 Managing Energy Risk: A Nontechnical Guide to Markets and Trading statement, 62; operations, 63; analysis, 64-67, 166; assignment, 151, 156-157; process, 165-202; profit diagrams, 184-191; organization, 201; desired portfolio, 233-234; objectives, 251, 253; approach, 275-276 Portfolio objectives (achievement), 251, 253 Portfolio process, 165-202: hedging cycle, 165-167; defining the portfolio (RMPP), 167-169; today’s value and payoff diagram, 170178; options, 179-185; profit diagrams for portfolios, 184-191; generator’s initial portfolio, 191, 197-201; profits and losses (decomposition), 192-196; endnotes, 201-202 Portfolio profit diagrams, 184-191: synthetic call, 186, 188; load curtailment contract, 187-190; two call portfolio, 190-191 Portfolio sensitivity, 220-221 Portfolio/book assignment, 151, 156157: portfolio, 157; sub-portfolio, 157; book, 157 Position (contract), 152 Power industry portfolio, 275 Power market, 28-32, 93, 243: characteristics, 29-30; power price inelasticity, 30-31; volumetric risk, 31-32; liquidity factors, 243 Power price inelasticity, 30-31 Predicting profits and losses, 193-196: accuracy, 194-196 384 Preparation (deal), 154-155 Present value/payoff, 170-178: market change, 171; payoff diagram, 170-178 Price behavior, 30-31, 104, 114-121, 197: inelasticity, 30-31; reversion, 115, 120-121; quantitative vs fundamental modeling, 117; curves, 118-119; drop, 197 Price curves, 118-119 Price discovery, 26-27, 148 Price drop, 197 Price inelasticity, 30-31 Price mean reversion, 115, 120-121 Price modeling, 117 Price risk measurement, 210-213: volatility measures risk, 211; looking out the windshield, 211; looking at controls and simulations, 211 Price risk on payoff diagram, 213-214: zero risk, 213-214; simple risk, 213-214; composite risk, 213214; high risk, 214 Price risk plotting, 220-223 Price risk, 109-139, 171, 204-205, 210-214, 220-223, 240: price-risk pyramid, 109-139, 171; measurement, 210-213; payoff diagram, 213-214; plotting, 220-223; price spike, 220-221; hedging, 240 Price risk/price spike, 220-221 Price spike, 85-86, 197, 220-221: short capacity, 197; price risk, 220-221 wengler new index pp373-390 10/16/02 2:08 PM Page 385 Index Price volatilities, 104-105, 112-113 Price-risk pyramid, 109-139, 171: building block approach, 111; modeling consistency, 111; integrated systems, 111; assumptions, 112-114; forward price behavior, 114-118; forward price curves, 118-119; market information, 119-122; volatilities, 123-126; correlations, 126-127; valuation layer, 128-130; options and value of choice, 130-135; risk and probability, 135-136; risk sensitivity analysis, 136-138; value at risk (VaR), 138-139 Q Qualifying facilities, 34 Quality contracts (hedging), 244 Quantifying risk limits, 228-230: how to quantify, 228; strategic expression, 229-230; informed discussion, 229-230; stress testing, 229230; actual performance, 229-230 Quantitative model, 40, 117, 121-122: vs fundamental model, 117 Quantity of power, 152 Probability (change), 135-136 Product line, 82-84 Profit and loss risk, 204-205 Profit diagrams (portfolios), 180, 182, 184-191: synthetic call, 186, 188; load curtailment contract, 187190; two call portfolio, 190-191 R Range of expectations, 123-126 Rate of return, 75-80 Real options, 42-43 Profit objectives, 198-201 Real prices (modeling), 130 Profits and losses (decomposition), 66, 136, 192-196: model validation, 192; market validation, 192; executive reporting, 192; prediction, 193-194; checking accuracy of prediction, 194-196 Records and reports, 319-320 Public Utility Regulatory Policies Act (PURPA), 33-34 Put (option), 135 Recouping costs, 262 Region (market), 23, 25 Regulated industry/market, 78-80 Relative value, 130-135 Reliability risk, 270-274 Reluctant utility, 6-9: identification, 67; recommendations, Reregulation, 270 Responsibility (policies and procedures), 60-61 385 wengler new index pp373-390 10/16/02 2:08 PM Page 386 Managing Energy Risk: A Nontechnical Guide to Markets and Trading Retail positions, 169 Risk and probability, 135-136 Risk basics, 11-12 Risk control, 149-150, 211-213: credit risk, 149-150 Risk engine, 257 Risk exposure guidelines, 57, 293-294 Risk governance, 61, 67 Risk limit quantification, 12, 61, 225230: decisions, 225-226; how to quantify, 228; strategic expression, 229-230; informed discussion, 229-230; stress testing, 229230; actual performance, 229-230 Risk limits, 12, 61, 225-230: quantification, 229-230 Risk Management Committee, 54-55, 67 Risk Management Policies Procedures (RMPP), 47-50 and Risk management policies and procedures, 47-69, 286-298, 307-314: Risk Management Policies and Procedures (RMPP), 47-50; assumptions about Board/upper management, 50-52, 60; energy trading and derivatives policies, 53-59; RMPP outlines, 62-63; measurement and enforcement, 63-64; portfolio questions, 64-67; governance issues, 67; RMPP documents, 68; endnotes, 68-69 Risk management policy, 286-298: organizational structure/responsibilities, 286-288; employee requirements, 289-293; risk expo- 386 sure guidelines, 293-294; accounting and tax, 294-296; legal review, 296; self-protecting/internal controls, 296-298; intercompany/related party activities, 298 Risk management procedures, 307314 Risk management, 5-9, 47-69, 75-80, 105-106, 166, 206-210, 286-298, 307-314: reluctant utility, 6-9; identification, 6-7; recommendations, 8; policies and procedures, 47-69, 286-298, 307-314; Risk Management Committee, 54-55, 67; tools, 62; mindset, 75-80; activities, 105-106; human risk, 206-210; trading accounts, 207; account management, 207; loss of trust, 207-209; rogue trading, 207-208; moral hazard, 207-208; management focus, 208; appropriate behavior, 208; human error, 209-210; trading perceptions, 209; management priorities, 209210 Risk Manager, 55, 91-94, 98-99, 166: qualities, 93-94; asset management, 98-99; input, 98-99 Risk measurement (portfolio change), 203-231: gamma criterion, 203; risk variables, 204-206; risk management, 206-210; price risk measurement, 210-213; price risk on payoff diagram, 213-214; delta and gamma (payoff and profit diagrams), 215-220; plotting price risk by time bucket, 220-223; credit risk, 224; volumetric and wengler new index pp373-390 10/16/02 2:08 PM Page 387 Index transmission risk, 224-225; setting risk limits, 225-229; quantifying risk limits, 228-230; endnotes, 231 RMPP objectives, 201: motivation, 201; portfolio organization, 201; profit and loss, 201; authority/ monitoring, 201 Risk monitoring/management, 317318 RMPP outlines, 62-63 Risk sensitivity, 65, 136-138, 166, 217-219: analysis, 136-138; deepout-of-the-money, 217; out-ofthe-money, 217; near-the-money, 217; at-the-money, 218; in-themoney, 219; deep-in-the-money, 219 Roster (staff), 10-11, 89-102: major positions, 89-90; success in emerging markets, 91-94; concentric circles model (asset management), 94-102 Rogue trading, 207-208 Risk simulation, 211-213 Risk system (trading), 156-157 Risk variables, 204-206: market, 204205; price, 204-205; profit and loss, 204-205; credit, 204-205; volumetric, 204-205; modeling, 204-205; marketing, 204-205; human, 204-206; operational, 204, 206; transmission, 205 Risk-adjusted expectations, 40-41 Risk-return strategy, 10, 71-87, 198200: treasury, 72-74, 199-200; speculation, 72-75, 200; arbitrage, 72-73, 81, 200; market maker, 72-73, 82-84, 200; beyond rate-of-return, 75-80; conflicting strategies, 84-86; endnotes, 87; profit objectives, 198-200 RMPP concept, 2, 17 RMPP documents, 68 RMPP measurement/enforcement, 6364 S Sample profit objectives (risk-return strategy), 198-200: treasury, 199200; market maker, 200; arbitrage, 200; speculation, 200 Savings and loan-type crisis, 274-275 Seasonality functions, 122 Self-protecting/internal controls, 296298 Setting risk limits, 225-229: which risks, 225-226; enforcement, 226228; detail to measure, 228; how to quantify limits, 228; monitoring/updating limits, 228-229 Settlement (delivery/payment), 152, 157-162: contract, 152; comparison by market, 158-159; expiration date rules, 158-160; delivery specifications, 160-162; delivery rules, 160-161; payment rules, 160, 162 387 wengler new index pp373-390 10/16/02 2:08 PM Page 388 Managing Energy Risk: A Nontechnical Guide to Markets and Trading Short (sold) contract, 184 Stress testing, 166, 229-230 Short call, 184-185 Structured products, 21-22, 99-100, 133 Short capacity, 197 Short put, 184-185 Simple risk, 213-214 Source code value, 262 Spark spread, 19-45 Special needs teams, 100-102: Director of Information Technology, 100-101; lawyers, 101; auditors, 101; consultants, 101102; committees, 102 Speculation, 23, 72-75, 147, 200, 241: strategy, 72-75; motivation, 147; objectives, 200; positions, 241 Success in emerging markets, 91-94: leadership in new market conditions, 91-92; risk managers, 9194; traders, 92-93; cultural differences, 93, emerging markets, 94 Supply and demand (balance), 27 Swap, 128 Swing options, 134 Swing quantity controls, 152 Symbols (definition), 15-17 Synthetic call, 186, 188 Sponsorship, 10 Staff (personnel), 10-11, 89-102, 259: translator, 90; facilitator, 90; gladiator, 90; information technology, 259 T Standardized contracts, 25 Technical analysis, 166 Statistical arbitrage strategy, 83 Term structure (forward prices and volatilities), 112-113 Stochastic model, 121 Straddles (option), 135 Strangles (option), 135 Strategic expression, 229-230 Strategies (risk-return), 10, 72-75, 8184: treasury, 72-74; speculation, 72-75; arbitrage, 72-73, 81; market maker, 72-73, 82-84 Strategy (hedging objectives), 234238 Strategy conflicts, 84-86 388 Tax accounting, 58, 294-296, 304-306 Terms (definitions), 325-368 Theta change, 193-194 Things to checklist, 1-17: walk before you run, 3-4; balance Wall Street and Main Street, 5; markto-market, 5-6; risk management, 6-9; risk-return strategy, 10; political sponsor, 10; complete roster, 10-11; risk basics, 11-12; risk limits, 12; budget for objectives, 12; networking, 12-13; book organi- wengler new index pp373-390 10/16/02 2:08 PM Page 389 Index zation, 13-15; special symbols, 15-17 Thinking beyond rate-of-return, 7580: risk management mindset, 7580; difference from traditional financial analysis, 76-77; value based on market opportunity, 7778; before deregulation, 78-80 Third-party credibility, 262 Time bucket price risk plotting, 220223 Time of expiration, 172 Time of observation, 172 Today’s value and payoff diagram, 170-178: market change, 171; payoff diagram, 170-178 Trade horizon, 151-152 Traders, 55-57, 92-93, 97-98: qualities, 93; asset management, 97-98 Trading and derivatives policies, 281320: outline, 281-285; risk management policy, 286-298; trading policies, 298-307; credit policies and risk management procedures, 307-314; customer appropriateness evaluation, 314-316; training programs, 317; back office policies and procedures, 317-320; disclosure obligations, 320 Trading and portfolio management system, 256-258: market price signals to system, 256; deal capture, 257; risk engine, 257; book management, 257 Trading policies, 298-307: operations, 298-302; administration, 302304; accounting and tax, 304-306; legal review, 306-307 Trading/risk system, 156-157 Traditional financial analysis, 76-77 Training programs (counterparty evaluation), 317 Transaction complexity evaluation, 315-316 Transaction details, 152 Translator duties, 90 Transmission assets/aspects, 169 Transmission risk, 205, 224-225 Treasury, 72-74, 85-86, 146, 199-200: strategy, 72-74, 85-86; motivation, 146; objectives, 199-200 Trust (loss of), 207-209 Two-call portfolio, 190-191 Two-factor variable (model), 120 U Univol model, 142 Updating/monitoring risk limits, 228229 Trading operation accounts, 207 Trading perceptions, 209 389 wengler new index pp373-390 10/16/02 2:08 PM Page 390 Managing Energy Risk: A Nontechnical Guide to Markets and Trading V W Valuation (portfolio), 77-78, 166, 128130, 198: price-risk pyramid, 128-130 Walk before you run, 3-4 Valuation layer (price-risk pyramid), 128-130: real prices and modeling, 130 Value at risk (VaR), 65, 136, 138-139, 166: analysis, 136; market-driven VaR, 138-139; variance/covariance, 138-139; Monte Carlo simulations, 139 Value based on market opportunity, 77-78 Value of choice (options), 130-135 Value-at-risk analysis, 211-212 Variable-price contracts, 128 Variance/covariance, 66, 138-139 Vega change, 193-194 Vendors (information technology), 263-265: heritage, 264-265 Vision (deal), 154 Volatilities (price/market), 104-105, 112-113, 123-126: historical volatility, 124-125; marketimplied volatility, 125; optionimplied volatility, 125; modelimplied volatility, 125; model functions, 125-126; mark-tomodel concept, 125-126 Volatility measures risk, 211 Volumetric risk, 31-32, 204-205, 224225 390 What if? analysis, 166 XYZ Zero premium option, 187-189 Zero risk, 213-214 ... company operating in this environment learn to analyze its risks and manage them appropriately And, it is important that risk managers understand and internalize the concepts behind risk management... Nontechnical Guide to Markets and Trading The manager’s job is to manage (A novel concept!) When managing a complex new business unit such as trading and risk management, the manager’s secret weapon lies... about risk over several decades, wengler 01 pp001-018 10/16/02 1:17 PM Page Managing Energy Risk: A Nontechnical Guide to Markets and Trading Task Walk Before You Run Balance “Wall Street” and “Main