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Date: Tue, 1 Aug 2000 06:43:00 -0700 (PDT)
From: julie@lacima.co.uk
To: vince.j.kaminski@enron.com
Subject: Preface for book
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Vince,
?
Hope you are well.
?
We spoke a while ago about who should write the preface for the book, and =
=20
you kindly offered that you would provide this.? Is this still  possible?? =
We=20
realise that you are extremely busy, so Chris and Les went  ahead and wrote=
=20
something, which is below, and if you want to review, change or  re-write?t=
he=20
preface, that would be very appreciated.? Let me know  what your thoughts a=
re.
?
Thanks,
Julie
(we're getting close)
?
?=20

Preface

?

?

?

One of our main objectives in  writing Energy Derivatives: Pricing and Risk=
=20
Management has been to bring  together as many of the various approaches fo=
r=20
the pricing and risk management  energy derivatives as possible, to discuss=
=20
in-depth the models, and to show how  they relate to each other.? In this =
=20
way we hope to help the reader to analyse the different models, price a wid=
e =20
range of energy derivatives, or to build a risk management system which use=
s=20
a  consistent modelling framework.? We  believe that for practitioners this=
=20
last point is very important and we continue  to stress in our articles and=
=20
presentations the dangers of having flawed risk  management and giving=20
arbitrage opportunities to your competitors by using  ad-hoc and inconsiste=
nt=20
models for different instruments and markets (see also OTHERS WHO PROPOSE=
=20
CONSISTENT  MODELS?).? However, it is not  our wish to concentrate on one=
=20
particular model or models, at the exclusion of  the others because we=20
believe that the choice should rest with the user  (although it will probab=
ly=20
be clear from our discussions the model(s) we  prefer).? We therefore try a=
nd=20
give  as clear account as possible of the advantage and disadvantages of al=
l=20
the  models so that the reader can make an informed choice as to the models=
=20
which  best suit their needs.

?

In order to meet our objectives the  book is divided into 11 chapters.?  In=
=20
chapter 1 we give an overview of the fundamental principals needed to  mode=
l=20
and price energy derivatives which will underpin the remainder of the  book=
.?=20
In addition to introducing  the techniques that underlie the Black-Scholes=
=20
modelling framework we outline  the numerical techniques of trinomial trees=
=20
and Monte Carlo simulation for  derivative pricing, which are used througho=
ut=20
the book.

?

In Chapter 2 we discuss the  analysis of spot energy prices.? As  well as=
=20
analysing empirical price movements we propose a number of processes  that=
=20
can be used to model the prices.?  We look at the well-know process of=20
Geometric Brownian Motion as well as  mean reversion, stochastic volatility=
=20
and jump processes, discussing each and  showing how they can be simulated=
=20
and their parameters estimated.

?

Chapter 3, written by Vince  Kaminski, Grant Masson and Ronnie Chahal of=20
Enron Corp., discusses volatility  estimation in energy commodity markets.?=
 =20
This chapter builds on the previous one.? It examines in detail the methods=
, =20
merits and pitfalls of the volatility estimation process assuming different=
 =20
pricing models introduced in chapter 2.?  Examples from crude, gas, and=20
electricity markets are used to illustrate  the technical and interpretativ=
e=20
aspects of calculating volatility.

?

Chapter 4 examines forward curves  in the energy markets.? Although  such=
=20
curves are well understood and straight-forward in the most financial =20
markets, the difficulty of storage in many energy markets leads to less wel=
l =20
defined curves.? In this chapter we  describe forward price bounds for ener=
gy=20
prices and the building of forward  curves from market instruments.? We =20
outline the three main approaches which have been applied to building=20
forward  curves in energy markets; the arbitrage approach, the econometric=
=20
approach, and  deriving analytical values by modelling underlying stochasti=
c=20
factors.

?

Chapter 5 presents an overview of  structures found in the energy derivativ=
e=20
markets and discusses their uses.? Examples of products analysed in this =
=20
chapter include a variety of swaps, caps, floors and collars, as well as=20
energy  swaptions, compound options, Asian options, barrier options, lookba=
ck=20
options,  and ladder options.

?

Chapter 6 investigates single and  multi-factor models of the energy spot=
=20
price and the pricing of some standard  energy derivatives.? Closed form =
=20
solutions for forward prices, forward volatilities, and European option=20
prices  both on the spot and forwards are derived and presented for all the=
=20
models in  this chapter including a three factor, stochastic convenience=20
yield and interest  rate model.

?

Chapter 7 shows how the prices of  path dependent and American style option=
s=20
can be evaluated for the models in  Chapter 6.? Simulation schemes are =20
developed for the evaluation of European style options and applied to a=20
variety  of path dependent options.? In order  to price options which=20
incorporate early exercise opportunities, a trinomial  tree scheme is=20
developed.? This tree  is built to be consistent with the observed forward=
=20
curve and can be used to  price exotic as well as standard European and=20
American style options.

?

Chapter 8 describes a methodology  for valuing energy options based on=20
modelling the whole of the market observed  forward curve.? The approach=20
results  in a multi-factor model that is able to realistically capture the=
=20
evolution of a  wide range of energy forward curves.?  The user defined=20
volatility structures can be of an extremely general  form.? Closed-form=20
solutions are  developed for pricing standard European options, and efficie=
nt=20
Monte Carlo  schemes are presented for pricing exotic options.? The chapter=
=20
closes with a discussion of  the valuation of American style options.

?

Chapter 9 focuses on the risk  management of energy derivative positions.? =
=20
In this chapter we discuss the management of price risk for institutions =
=20
that trade options or other derivatives and who are then faced with the=20
problem  of managing the risk through time.?  We begin with delta hedging a=
=20
portfolio containing derivatives and look  at extensions to gamma hedging =
=01)=20
illustrating the techniques using both spot and  forward curve models.? The=
=20
general  model presented in Chapter 8 is ideally suited to multi-factor=20
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)=
=20
applied to portfolios containing  energy derivative products.? After =20
discussing the concept of the measure, we look at how the key inputs =20
(volatilities, covariances, correlations, etc) can be estimated.? We then=
=20
compare the fours major  methodologies for computing VaR; Delta, Delta-gamm=
a,=20
historical simulation and  Monte-Carlo simulation, applying each to the sam=
e=20
portfolio of energy  options.? In this chapter we also  look at testing the=
=20
VaR estimates for various underlying energy market  variables.

?

Finally, in Chapter 11 we review  modelling approaches to credit risk.?  We=
=20
look in detail at two quite different approaches, CreditMetrics (J. P. Morg=
an=20
(1997)) and  CreditRisk+ (Credit Suisse Financial  Products (1997)) for whi=
ch=20
detailed information is publicly available.? Together these provide an=20
extensive set  of tools with which to measure credit risk.? We present=20
numerical examples of  applying these techniques to energy derivatives.

?
Before  we begin we stress that the models and methods we present in this=
=20
book are tools  which should be used with the benefit of an understanding o=
f=20
how both the =01+tool=01,  and the market works.? The  techniques we descri=
be are=20
certainly not =01&magic wands=018 which can be waved at  data and risk mana=
gement=20
problems to provide instant and perfect solutions.? To quote from the=20
RiskMetrics Technical  Document =01&=01( no amount of sophisticated analyti=
cs will=20
replace experience and  professional judgement in managing risk.=018.?  How=
ever,=20
the right tools, correctly used make the job a lot  easier!