From: vince.kaminski@enron.com
To: julie@lacima.co.uk
Cc: vince.kaminski@enron.com
Date: 2000-08-03 15:30:00+00:00
Subject: Re: Preface for book

Julie,

No problem. It's your call but Chris should also be mentioned as number one.

Vince





"Julie" <julie@lacima.co.uk> on 08/03/2000 03:06:28 PM
To: "Vince J Kaminski" <Vince.J.Kaminski@enron.com>
cc:  
Subject: Re: Preface for book



Vince,
Thanks for this.?? 
?
Are you OK with us using your name for this?? 
?
Julie
----- Original Message ----- 
From:  Vince J Kaminski 
To: julie@lacima.co.uk 
Sent: Wednesday, August 02, 2000 2:11  PM
Subject: Re: Preface for book




---------------------- Forwarded by Vince J  Kaminski/HOU/ECT on 08/02/2000 
08:16
AM  ---------------------------


Vince J Kaminski
08/02/2000 08:09  AM

To:?? "Julie" <julie@lacima.co.uk> @  ENRON
cc:?? Vince J Kaminski/HOU/ECT@ECT, Grant  Masson/HOU/ECT@ECT
Subject:? Re: Preface for book? (Document  link: Vince J Kaminski)

Julie,

The introduction looks fine. I  have made some cosmetic changes
(typos and split infinitives that slipped  by). You can safely ignore most of
them.
English is not even my second  language.

The corrections are in pink.

Vince
(See attached  file: Intro0802.doc)




"Julie" <julie@lacima.co.uk> on 08/01/2000  07:43:10 AM

To:?? "VinceJKaminski" <Vince.J.Kaminski@enron.com>
cc:
Subject:?  Preface for book



Vince,

Hope you are well.

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







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.



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.



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.



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.



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.



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.



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.



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.



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.



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.



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.



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.


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 wands?  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.?. ? However,  the right tools, 
correctly
used make the job a lot?  easier!