Risk Management in Commodity Markets

Commodities are one of the fastest growing markets worldwide. Historically misunderstood, generally understudied and undervalued, certainly underrepresented, commodities are suddenly receiving the attention they deserve. After equities, fixed income and credit, this strategic asset class that has existed since the beginning of time is finally becoming a subject of research and modelling work on the part of academics and practitioners.

Bringing together some of the leading authors in their fields, this book focuses on the risk management issues associated with both soft and hard commodities such as energy, weather, agriculturals, metals and shipping. Taking the reader through the various aspects of the commodities markets, the authors discuss the intricacies of modelling spot and forward prices, as well as the design of new Futures markets. The book also addresses the use of options and other derivative contract forms for hedging purposes, as well as supply management in commodity markets. The implications of climate policy in different continents; the various freight derivatives markets and products used to manage shipping and freight risk in a global commodity world are also presented and explained.

It will be valuable reading for energy and mining companies corporates, utilities' practitioners, commodity and cash derivatives traders in investment banks, CTA's and hedge funds managers alike.

Preface xi
About the Editor xv
About the Contributors xvii
1 Structural Models of Commodity Prices 1
Craig Pirrong, University of Houston
1. 1 Introduction 1
1. 2 A Commodity Taxonomy 1
1. 3 Fundamental Models for Storable Commodities 2
1. 4 Non-Storable Commodities 6
1. 5 Summary 7
1. 6 References 7
2 Forward Curve Modelling in Commodity Markets 9
Svetlana Borovkova, Universiteit Amsterdam, and Hé lyette Geman, University of London and ESSEC
2. 1 Introduction 9
2. 2 Forward Curve Models for Non-Seasonal Commodities 14
2. 3 The Seasonal Forward Curve Model and its Extensions 17
2. 4 Principal Component Analysis of a Forward Curve 24
2. 5 Forward Curve Indicators 26
2. 6 Conclusions 31
2. 7 References 31
3 Integrating Physical and Financial Risk Management in Supply Management 33
Paul R. Kleindorfer, University of Pennsylvania and INSEAD
3. 1 Introduction 33
3. 2 A Primer On Previous Supply Management Contracting Literature 35
3. 3 A Modelling Framework and a Simple Illustrative Case 37
3. 4 Recent Contributions to the Optimal Contracting Literature 44
3. 5 Some Open Research Questions and Implications for Practice 46
3. 6 References 49
4 The Design of New Derivative Markets 51
Giovanni Barone-Adesi, The Swiss Finance Institute and The University of Lugano
4. 1 Introduction 51
4. 2 Determinants of Success of New Derivative Markets 52
4. 3 Price Discovery 53
4. 4 Trading, Clearing, and Margining 54
4. 5 Market Integrity 55
4. 6 Market Recovery 56
4. 7 Market Oversight 56
4. 8 Case Studies 57
4. 9 Conclusion 58
4. 10 References 58
5 Risk Premia of Electricity Futures: A Dynamic Equilibrium Model 61
Wolfgang Bü hler, University of Mannheim, and Jens Mü ller-Merbach, BHF-Bank Aktiengesellschaft
5. 1 Introduction 61
5. 2 The Dynamic Equilibrium Model 62
5. 3 Comparative Statics 64
5. 4 Empirical Study 73
5. 5 Conclusion 77
5. 6 References 80
6 Measuring Correlation Risk for Energy Derivatives 81
Roza Galeeva, Jiri Hoogland, and Alexander Eydeland, CMG, Morgan Stanley
6. 1 Introduction 81
6. 2 Correlation 81
6. 3 Perturbing the Correlation Matrix 82
6. 4 Correlation VaR 85
6. 5 Some Examples 85
6. 6 Discussion and Conclusions 88
6. 7 References 89
7 Precaution and a Dismal Theorem: Implications for Climate Policy and Climate Research 91
Gary W. Yohe, Wesleyan University and Richard S. J. Tol, Economic and Social Research Institute, Dublin
7. 1 Introduction 91
7. 2 A New Source of Concern: Weitzman's Dismal Theorem 93
7. 3 Implications of the "Dismal Theorem" 94
7. 4 Some Concluding Remarks 96
7. 5 References 97
8 Incentives for Investing in Renewables 101
Falbo Paolo, University of Brescia, Felletti Daniele and Stefani Silvana, University of Milano Bicocca
8. 1 Introduction and Background 101
8. 2 Subsidies for Energy 103
8. 3 The Model 104
8. 4 Statistical Estimations 107
8. 5 Risk Analysis 109
8. 6 Conclusions 114
8. 7 References 115
9 Hedging the Risk of an Energy Futures Portfolio 117
Carol Alexander, ICMA Centre, University of Reading
9. 1 Mapping Portfolios to Constant Maturity Futures 117
9. 2 The Portfolio and its Key Risk Factors 120
9. 3 Identifying the Key Risk Factors 123
9. 4 Hedging the Portfolio Risk 124
9. 5 Conclusions 127
9. 6 References 127
10 Spark Spread Options when Commodity Prices are Represented as Time Changed Processes 129
Elisa Luciano, University of Turin
10. 1 Spark Spread Options 130
10. 2 Time Change in a Nutshell 132
10. 3 Time Change and Commodity Prices 134
10. 4 An Application to PJM Electricity and NYMEX Natural Gas 137
10. 5 Conclusions and Further Research 144
10. 6 Appendix A: Modelling Specification in the Multivariate Case 145
10. 7 Appendix B: Alternative Modelling Specifications in the Univariate Case 147
10. 8 References 150
11 Freight Derivatives and Risk Management: A Review 153
Manolis G. Kavussanos, Athens University of Economics and Business, and Ilias D. Visvikis, ALBA Graduate Business School, Athens
11. 1 Introduction 153
11. 2 Forward Freight Agreements 154
11. 3 Freight Futures 157
11. 4 "Hybrid" (Cleared) FFAs 161
11. 5 Freight Options 162
11. 6 Empirical Research on Freight Derivatives 164
11. 7 Conclusion 178
11. 8 References 179
12 Mean-Reversion and Structural Breaks in Crude Oil, Copper, and Shipping 183
Hé lyette Geman, University of London and ESSEC Business School, and Steve Ohana, University of London
12. 1 Introduction 183
12. 2 Fundamentals of Copper, Crude Oil, and Shipping 186
12. 3 Defining Mean-Reversion 191
12. 4 Dataset and Unit Root Tests 193
12. 5 Conclusion 203
12. 6 References 204
13 Managing Agricultural Price Risk in Developing Countries 207
Julie Dana, The World Bank, and Christopher L. Gilbert, University of Trento and University of London
13. 1 The Liberalization Context 207
13. 2 Incidence of Risk Exposure 209
13. 3 Instruments and Problems 215
13. 4 Price Risk Management in the Developing Country Supply Chain 221
13. 5 Concluding Comments 234
13. 6 References 236
14 Gaining Exposure to Emerging Markets in Institutional Portfolios: The Role of Commodities 239
George A. Martin, Alternative Investment Analytics LLC and University of Massachusetts at Amherst, and Richard Spurgin, Clark University and Alternative Investment Analytics LLC
14. 1 Introduction 239
14. 2 Asset Markets and Economic Growth 239
14. 3 Are Emerging Markets Equity Markets and Commodity Markets Integrated? 244
14. 4 Implications for the Investment Policy of Institutional Investors 247
14. 5 Conclusion 254
14. 6 References 254
15 Case Studies and Risk Management in Commodity Derivatives Trading 255
Hilary Till, Premia Capital Management LLC
15. 1 Introduction 255
15. 2 Institutional Risk Management 258
15. 3 Proprietary-Trading Risk Management 265
15. 4 Hedge Fund Risk Management 266
15. 5 Fund-of-Hedge-Funds Diversification 266
15. 6 Market Risk Management 267
15. 7 Conclusion 288
15. 8 References 288
Index 293