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<td width="75%" valign="top"><p ALIGN="left"><big><b><big><big><strong>New Tools of the
Risk Trade</strong></big></big></b></big></p>
<font SIZE="2"><p></font><font size="4"><font face="Arial"><strong>BY<br>
SALLY STEWART<br>
PRODUCT MANAGER, RISK OF TRANSENERGY MANAGEMENT INC.</strong></font><br>
<small>(<em>originally published by PMA OnLine Magazine: 07/98</em>)</small></p>
</font><blockquote>
<blockquote>
<i><b><p><font face="Arial">As the structure of electricity industry unbundles,
specialized market sectors wield more sophisticated Wall Street-savvy financial tools and
trading systems. </font></b></i></p>
</blockquote>
</blockquote>
<p><font face="Arial">As regulatory change hammers and splinters apart the generation,
transmission, marketing and distribution functions of the electricity industry, newly
created niche market sectors are looking to help nail down risk with very sophisticated
and specialized risk management tools. Despite the chiseled-down functions of these new
market sectors, each sector’s ability to identify and manage risk will determine its
foothold in the deregulated future. </font></p>
<p><font face="Arial">Within this evolving "new world" order, companies will
need to determine what type(s) of risks – research and development, credit,
operational (transmission, distribution), market (fuel cost fluctuations, price exposure),
marketing, legal, customer service, customer aggregation (retailing function), regulatory
– they are willing to accept and manage. In the end, utilities and energy
conglomerates will be forced to determine: "What business do we want to be in?"
and "What risks do we want to take on?" </font></p>
<u><b><p><font face="Arial">Commodity Management and Cross-Over</b></u> </font></p>
<p><font face="Arial">After a company has decided to take on and manage the mercurial
commodities of energy – electricity, natural gas, coal – it should thoroughly
evaluate each commodity’s unique market risk and physical properties. Electricity,
especially, offers a number of challenges that are not apparent in other energy
commodities. Unlike the comforting ability to store natural gas to counter market upswings
or dips, non-storable electricity by its sheer physical make-up, exacts a minute-by-minute
demand. Consequently, electricity is branded as the most challenging commodity to manage.
Not only is the power industry faced with price volatility, as seen in other emerging
markets, the physical properties of power (electricity is "consumed" as it is
generated) offers less flexibility in managing trading positions. Embedded options are
often a significant component of physical power trades, providing traders with the ability
to shift on receipt and delivery alternatives. </font></p>
<p><font face="Arial">Yet another property that differentiates electricity from other
commodities is its hourly increments of receipts and deliveries. Due to this hourly
segmentation, the sheer volume of components for each trade is significantly larger in
power trading than in other commodities. As market niches develop further, the level of
resolution in power trading will likely become even finer. </font></p>
<p><font face="Arial">Pushing the challenge further, the feedstock for electricity is
other energy commodities, making cross-commodity arbitrage crucial. A prudent tool in
successful cross-commodity trading is a company’s ability to manage a "Btu
Book," positions stated in equivalent units of measure, used specifically for
cross-commodity trading. When assessing a deal – in coal, electricity, natural gas
– the Btu Book can help traders calculate how a trade breaks down into a single
common denominator of Btu units. </font></p>
<p><font face="Arial">To derive power prices from natural gas prices, the gross power cost
equals the gas cost multiplied by the heat rate; the net power cost equals the gross power
cost (plus the tolling cost and cost of transmission). The spark spread, or the difference
between the price of gas and the price of electricity at specified heat efficiencies, is
fast becoming a favorite tool among energy traders. </font></p>
<p><font face="Arial">Also opening up exciting new opportunities in the energy marketplace
is the practice of coal tolling. Coal tolling, the conversion of coal to electricity for a
fee, is currently making an attention-grabbing debut in power marketing. The tolling of
coal gives marketers, suppliers and generators a solid opportunity to manage the disparity
between coal and electricity prices while providing liquidity to use the volatility
between the two commodities. </font></p>
<p><font face="Arial">Already, the segregated and clear-cut boundaries between energy
sources are becoming blurred, somewhat indistinct. In the not-so-distant future, it will
become commonplace to routinely substitute and trade one form of energy for another,
without ever first considering the diverse physical properties of each commodity. </font></p>
<u><b><p><font face="Arial">Wall Street Savvy</b></u> </font></p>
<p><font face="Arial">Due in part to the influx of Wall Street-savvy traders, marketers
and arbitrageurs into the electricity industry, the buzz of water-cooler talk now includes
the likes of "floors, caps, collars, lookbacks and butterflies." </font></p>
<p><font face="Arial">In short order, energy trading has accelerated from plain vanilla to
increasingly exotic flavors of options, risk management and hedging techniques like:</font><ul>
<li><font face="Arial"><strong>Lookback</strong> – an option that grants the holder the
right to buy at the lowest referenced price or sell at the highest referenced price
reached, during the life of the option ( an option is a contract that gives the holder the
right, but not the obligation, to buy or sell at a certain price prior to or upon an
agreed date).<br>
<br>
</font></li>
<li><font face="Arial"><strong>Floor</strong> – an option contract which sets a minimum
sales price for the holder. By establishing a minimum sales price, the holder is protected
against falling commodity prices.<br>
<br>
</font></li>
<li><font face="Arial"><strong>Cap</strong> – also known as a ceiling, is an option
which sets a maximum purchase price for the holder. By establishing a maximum price to be
paid, the holder is protected from rising commodity prices.<br>
<br>
</font></li>
<li><font face="Arial"><strong>Collar</strong> – an option position which combines a
floor and a cap; establishing commodity price settlements within a defined range. A
producer may use a collar to protect against declining commodity prices by limiting the
extent of upside benefits related to market increases. With a zero or "costless
collar", the strike prices for the floor and cap are set so that the premium charges
are eliminated. <br>
<br>
</font></li>
<li><font face="Arial"><strong>Barrier Option</strong> – an exotic option which is
enacted (known as "Knock-in") or terminated (known as "Knock-out") as
referenced prices reach specified levels in the contract. <br>
<br>
</font></li>
<li><font face="Arial"><strong>Swaptions</strong> – an option to purchase or sell a
swap at some future date and may include the ability to increase or decrease the swap
volume or increase the period of the swap. <br>
<br>
</font></li>
<li><font face="Arial"><strong>Double Downs</strong> – a swap with an embedded option
that allows the seller to reduce the notional quantity of the contract. In exchange, the
holder receives a more desirable price. A Double Up is the reverse scenario. <br>
<br>
</font></li>
<li><font face="Arial"><strong>Trigger Deal</strong> – a form of option, which allows
the holder to set a deal price, based on an exchange-traded commodity price. <br>
<br>
</font></li>
<li><font face="Arial"><strong>Butterfly Spreads</strong> – the simultaneous sale of an
at-the-money straddle (a straddle is the combo of a put and a call with the same
expiration date and the same strike price) and the purchase of an out-of-the-money
strangle (a strangle is the combo of a put and call with the same expiration date, but
different strike prices) reducing the risk of market movements to a fixed amount. </font></li>
</ul>
<p><font face="Arial">Another risk management tool plied by the financial community, and
recently employed by the energy community, is Value-at-Risk (VAR). A statistical measure
of the largest likely loss expected over a given time with a given probability,
Value-at-Risk calculates commodity risk exposure from trading activities. VAR
methodologies model how market factors will change over the time the trading company holds
a commodity position, and how these changes affect each other. The VAR analysis can assist
energy traders, risk managers and upper management professionals evaluate the impact of
these changes on the company’s portfolio. </font></p>
<p><font face="Arial">For example, if a firm estimates its VAR over 1 week to be $5
million with a 95% confidence level, the company then would be expected to lose less than
$5 million for 95 weeks out of 100. This estimate is based on the market conditions and
composition of the portfolio at the time of the calculation. Since these parameters are
constantly changing, most companies are performing VAR calculations on a daily basis.
Particularly for upper management, VAR can be used to report risk, define risk-reward
ratios of trading desks and evaluate trader performance. </font></p>
<p><font face="Arial">Value-at-Risk determines commodity risk exposure from trading
activities through the principal methods of Monte Carlo simulations, estimated
variance-covariance (correlation or short-term variation) and historical simulations.
Statistical methods may be supplemented with stress tests, or worst-case/ "what
if" scenario testing. The choice among the various VAR methodologies largely depends
upon the composition and complexity of a company’s portfolio. Many of the VAR
methodologies are currently packaged in a widening cyber-genre of energy risk management
software systems. </font></p>
<u><b><p><font face="Arial">Commodity Trading Tools</font></b></u></p>
<p><font face="Arial">From power marketers or arbitrageurs who buy and sell electricity as
a commodity, to the new marketing division of unbundled utilities, to retail level
distribution companies, it is clear that commodity trading systems will play a key role in
the successful development of each organization. The "real-time" trading
dynamics of this evolving market has resulted in a demand for a whole new breed of trading
systems. Not only do the information requirements differ for the specialized units, the
complexities of the power industry place even higher demands on finding successful
commodity trading solutions. </font></p>
<p><font face="Arial">In order to meet the needs of power marketers or arbitrageurs, a
commodity trading system may be adequate if it aggregates physical and financial positions
from a standard product perspective for the forward months, with the ability to query
non-standard positions. However, for spot month trading, the power marketer requires the
commodity trading system to support physical and financial position management on an
hourly basis. With this level of resolution, traders can assess the impact of standard and
non-standard product positions with schedulers completing physical receipt and delivery
transactions. </font></p>
<p><font face="Arial">In contrast, the commodity system requirements of a power marketing
arm of a utility are far more comprehensive than that of a power arbitrageur. The hourly
resolution of both physical and financial positions for all forward periods is essential
to this type of organization. With this level of resolution, the trades are disaggregated
into the individual risk components for specific time periods, so the system must be
robust. Also, many of these organizations have portfolios well beyond the one-year time
frame, so the ability to disaggregate the risks, and then aggregate on selected criteria
is critical for traders and risk managers, since this level of resolution quickly becomes
impossible to manage. Additionally, real-time position updates of a trading system is a
necessary feature for these organizations as they assess trading strategies, power supply
and wheeling capabilities with market opportunities. </font></p>
<p><font face="Arial">In effect, a first-rate energy trading system must integrate both
derivatives and physical trades for risk management in a real-time environment in order to
meet the demands of the marketplace. Further, a command of the complexities of scheduling
receipts, deliveries and transmission of the underlying commodity is essential. The
commodity trading system that offers the ability to manage a Btu Book, incorporating
multiple commodities and risks, is the wave of the future. </font></p>
<p><font face="Arial">In the soon-to-be restructured U.S. power market, competition and
sheer market force will make the industry more efficient by carving out specialized niches
and widening the assortment of risk management tools and trading systems. With certainty,
the current spin-off of previously integrated business functions will continue, as
organizations shed more and more risks that no longer fit into the "new world"
corporate risk strategy. </font></p>
<hr>
<p><small><font face="Arial">Sally Stewart is Product Manager of <strong>Risk of
TransEnergy Management Inc.</strong>, a software development company, offering integrated
energy trading systems. Transenergy's website can be located at <a href="http://www.transenergy.com">http://www.transenergy.com</a></font></small></td>
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