From: julie@lacima.co.uk
To: vince.j.kaminski@enron.com
Date: 2000-08-01 13:43:00+00:00
Subject: Preface for book

Vince,
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Hope you are well.
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We spoke a while ago about who should write the preface for the book, and  
you kindly offered that you would provide this.? Is this still  possible?? We 
realise that you are extremely busy, so Chris and Les went  ahead and wrote 
something, which is below, and if you want to review, change or  re-write?the 
preface, that would be very appreciated.? Let me know  what your thoughts are.
?
Thanks,
Julie
(we're getting close)
?
? 

Preface

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One of our main objectives in  writing Energy Derivatives: Pricing and Risk 
Management has been to bring  together as many of the various approaches for 
the pricing and risk management  energy derivatives as possible, to discuss 
in-depth the models, and to show how  they relate to each other.? In this  
way we hope to help the reader to analyse the different models, price a wide  
range of energy derivatives, or to build a risk management system which uses 
a  consistent modelling framework.? We  believe that for practitioners this 
last point is very important and we continue  to stress in our articles and 
presentations the dangers of having flawed risk  management and giving 
arbitrage opportunities to your competitors by using  ad-hoc and inconsistent 
models for different instruments and markets (see also OTHERS WHO PROPOSE 
CONSISTENT  MODELS?).? However, it is not  our wish to concentrate on one 
particular model or models, at the exclusion of  the others because we 
believe that the choice should rest with the user  (although it will probably 
be clear from our discussions the model(s) we  prefer).? We therefore try and 
give  as clear account as possible of the advantage and disadvantages of all 
the  models so that the reader can make an informed choice as to the models 
which  best suit their needs.

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In order to meet our objectives the  book is divided into 11 chapters.?  In 
chapter 1 we give an overview of the fundamental principals needed to  model 
and price energy derivatives which will underpin the remainder of the  book.? 
In addition to introducing  the techniques that underlie the Black-Scholes 
modelling framework we outline  the numerical techniques of trinomial trees 
and Monte Carlo simulation for  derivative pricing, which are used throughout 
the book.

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In Chapter 2 we discuss the  analysis of spot energy prices.? As  well as 
analysing empirical price movements we propose a number of processes  that 
can be used to model the prices.?  We look at the well-know process of 
Geometric Brownian Motion as well as  mean reversion, stochastic volatility 
and jump processes, discussing each and  showing how they can be simulated 
and their parameters estimated.

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Chapter 3, written by Vince  Kaminski, Grant Masson and Ronnie Chahal of 
Enron Corp., discusses volatility  estimation in energy commodity markets.?  
This chapter builds on the previous one.? It examines in detail the methods,  
merits and pitfalls of the volatility estimation process assuming different  
pricing models introduced in chapter 2.?  Examples from crude, gas, and 
electricity markets are used to illustrate  the technical and interpretative 
aspects of calculating volatility.

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Chapter 4 examines forward curves  in the energy markets.? Although  such 
curves are well understood and straight-forward in the most financial  
markets, the difficulty of storage in many energy markets leads to less well  
defined curves.? In this chapter we  describe forward price bounds for energy 
prices and the building of forward  curves from market instruments.? We  
outline the three main approaches which have been applied to building 
forward  curves in energy markets; the arbitrage approach, the econometric 
approach, and  deriving analytical values by modelling underlying stochastic 
factors.

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Chapter 5 presents an overview of  structures found in the energy derivative 
markets and discusses their uses.? Examples of products analysed in this  
chapter include a variety of swaps, caps, floors and collars, as well as 
energy  swaptions, compound options, Asian options, barrier options, lookback 
options,  and ladder options.

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Chapter 6 investigates single and  multi-factor models of the energy spot 
price and the pricing of some standard  energy derivatives.? Closed form  
solutions for forward prices, forward volatilities, and European option 
prices  both on the spot and forwards are derived and presented for all the 
models in  this chapter including a three factor, stochastic convenience 
yield and interest  rate model.

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Chapter 7 shows how the prices of  path dependent and American style options 
can be evaluated for the models in  Chapter 6.? Simulation schemes are  
developed for the evaluation of European style options and applied to a 
variety  of path dependent options.? In order  to price options which 
incorporate early exercise opportunities, a trinomial  tree scheme is 
developed.? This tree  is built to be consistent with the observed forward 
curve and can be used to  price exotic as well as standard European and 
American style options.

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Chapter 8 describes a methodology  for valuing energy options based on 
modelling the whole of the market observed  forward curve.? The approach 
results  in a multi-factor model that is able to realistically capture the 
evolution of a  wide range of energy forward curves.?  The user defined 
volatility structures can be of an extremely general  form.? Closed-form 
solutions are  developed for pricing standard European options, and efficient 
Monte Carlo  schemes are presented for pricing exotic options.? The chapter 
closes with a discussion of  the valuation of American style options.

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Chapter 9 focuses on the risk  management of energy derivative positions.?  
In this chapter we discuss the management of price risk for institutions  
that trade options or other derivatives and who are then faced with the 
problem  of managing the risk through time.?  We begin with delta hedging a 
portfolio containing derivatives and look  at extensions to gamma hedging ) 
illustrating the techniques using both spot and  forward curve models.? The 
general  model presented in Chapter 8 is ideally suited to multi-factor 
hedging of a  portfolio of energy derivatives and this is also discussed.

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Chapter 10 examines the key risk  management concept of Value at Risk (VaR) 
applied to portfolios containing  energy derivative products.? After  
discussing the concept of the measure, we look at how the key inputs  
(volatilities, covariances, correlations, etc) can be estimated.? We then 
compare the fours major  methodologies for computing VaR; Delta, Delta-gamma, 
historical simulation and  Monte-Carlo simulation, applying each to the same 
portfolio of energy  options.? In this chapter we also  look at testing the 
VaR estimates for various underlying energy market  variables.

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Finally, in Chapter 11 we review  modelling approaches to credit risk.?  We 
look in detail at two quite different approaches, CreditMetrics (J. P. Morgan 
(1997)) and  CreditRisk+ (Credit Suisse Financial  Products (1997)) for which 
detailed information is publicly available.? Together these provide an 
extensive set  of tools with which to measure credit risk.? We present 
numerical examples of  applying these techniques to energy derivatives.

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Before  we begin we stress that the models and methods we present in this 
book are tools  which should be used with the benefit of an understanding of 
how both the +tool,  and the market works.? The  techniques we describe are 
certainly not &magic wands8 which can be waved at  data and risk management 
problems to provide instant and perfect solutions.? To quote from the 
RiskMetrics Technical  Document &( no amount of sophisticated analytics will 
replace experience and  professional judgement in managing risk.8.?  However, 
the right tools, correctly used make the job a lot  easier!