Energy Trading and Risk Management	3
	Contents	9
	Preface	15
	Acknowledgments	27
	About the Author	29
	About the Contributors	31
	Chapter 1 Energy Markets Fundamentals	33
	1.1 Physical Forward and Futures Markets	35
	1.2 Spot Market	37
	1.3 Intraday Market	42
	1.4 Balancing and Reserve Market	42
	1.5 Congestion Revenue Rights, Financial Transmission Rights, and Transmission Congestion Contracts	43
	1.6 Chapter Wrap-Up	44
	References	45
	Chapter 2 Quant Models in the Energy Markets: Role and Limitations	47
	2.1 Spot Prices	49
	2.1.1 Random Walk Jump-Diffusion Model	51
	2.1.2 Mean Reversion: Ornstein-Uhlenbeck Process	55
	2.1.3 Mean Reversion: Schwartz Type 1 Stochastic Process	57
	2.1.4 Mean Reversion with Jumps	57
	2.1.5 Two-Factor Model	58
	2.1.6 Negative Prices	59
	2.2 Forward Prices	60
	2.2.1 Forward and Futures Markets	60
	2.2.2 Contango and Backwardation	62
	2.3 Chapter Wrap-Up	63
	References	63
	Chapter 3 Plain Vanilla Energy Derivatives	65
	3.1 Definition of Energy Derivatives	66
	3.2 Global Commodity Exchanges	67
	3.3 Energy Derivatives Pricing Models	68
	3.4 Settlement	69
	3.5 Energy Derivatives Quant Models: Role and Limitations	70
	3.6 Options	72
	3.6.1 Volatility	74
	3.7 Vanilla Options	75
	3.7.1 Option Style	76
	3.7.2 Exchange-Traded and Over-the-Counter Options	76
	3.7.3 In-the-Money, At-the-Money, and Out-of-the-Money Options	77
	3.7.4 Put-Call Parity	78
	3.8 European Options	79
	3.9 American Options	82
	3.10 Swaps	84
	3.11 Swaps to Futures	86
	3.12 Chapter Wrap-Up	86
	References	86
	Chapter 4 Exotic Energy Derivatives	91
	4.1 Asian Options	92
	4.1.1 Classes of Asian Options	93
	4.1.2 Payoffs of Asian Options	94
	4.1.3 Solutions to Asian Options	95
	4.1.4 Asian Options in the Energy Markets	95
	4.2 Barrier Options	95
	4.2.1 Eight Types of Barrier Options	96
	4.2.2 Partial Barrier Options	97
	4.2.3 Solutions to Barrier Options	98
	4.2.4 Barrier Options in the Energy Markets	98
	4.3 Digital Options	98
	4.3.1 Types of Digital Options	99
	4.3.2 Solutions to Digital Options	101
	4.3.3 Digital Options in the Energy Markets	101
	4.4 Real Options	103
	4.4.1 Real Options in the Electric Power Markets	103
	4.4.2 Case Study: Real Options in the Oil Markets	104
	4.4.3 Limitations of the Real Options Valuation Paradigm	105
	4.5 Multiasset Options	106
	4.5.1 Pricing Multiasset Options	106
	4.6 Spread Options	107
	4.6.1 Crack Spreads	108
	4.6.2 Spark Spreads	114
	4.6.3 Dark Spreads	117
	4.7 Perpetual American Options	118
	4.7.1 Perpetual American Options in the Power Industry	119
	4.8 Compound Options	119
	4.8.1 Tolling Agreements: Example of Compound Options in Power Markets	121
	4.9 Swaptions	122
	4.9.1 Energy Swaptions	123
	4.10 Swing Options	124
	4.11 Chapter Wrap-Up	126
	References	126
	Chapter 5 Risk Management and Hedging Strategies	131
	5.1 Introduction to Hedging	134
	5.2 Price Risk	136
	5.3 Basis Risk	139
	5.3.1 Basis Risk Case Study	140
	5.3.2 Metallgesellchaft Case: Stack and Roll Hedging Disaster	141
	5.4 The Option “Greeks”	142
	5.5 Delta Hedging	143
	5.6 Gamma Hedging	145
	5.7 Vega Hedging	147
	5.8 Cross-Hedging Greeks	148
	5.9 Quant Models Used to Manage Energy Risk: Role and Limitations	148
	5.9.1 Regression Analysis	149
	5.9.2 Stress Test	152
	5.9.3 Value at Risk	155
	5.10 Chapter Wrap-Up	156
	References	156
	Chapter 6 Illustrations of Hedging with Energy Derivatives	159
	6.1 Hedging with Futures Contracts	161
	6.1.1 Case Studies and Examples: Hedging with Futures Contracts	162
	6.1.2 Risks Associated with Hedging with Futures Contracts	170
	6.2 Hedging with Forward Contracts	173
	6.3 Hedging with Options	175
	6.3.1 Case Study: Call Options Used to Set a “Cap” on Gasoline Prices	175
	6.3.2 Example: How Power Generators Use Options on Futures to Hedge	176
	6.3.3 Example: How End Users Utilize Options on Futures to Hedge	177
	6.3.4 Example: How Power Marketers Use Options on Futures to Hedge	177
	6.4 Hedging with Swaps	178
	6.4.1 Example: Fuel Swap	180
	6.4.2 Example: Electricity Swap	181
	6.4.3 Case Study: Natural Gas Basis Swap	182
	6.5 Hedging with Crack Spread Options	183
	6.5.1 Case Study: Hedging with Crack Spread Options	185
	6.6 Hedging with Spark Spreads	186
	6.6.1 Case Study: Power Producer Uses Spark Spread to Protect Margin	186
	6.7 Hedging with Other Energy Derivatives	189
	6.8 Chapter Wrap-Up	190
	References	190
	Chapter 7 Speculation	193
	7.1 Convergence of Energy and Financial Markets	194
	7.2 Trading Terminology	199
	7.3 Energy Products Trading Codes	201
	7.4 Futures Trading Symbols: Month Code Abbreviation	202
	7.5 Fundamental and Technical Analyses	203
	7.6 Trading Tools: Charts and Quotes	205
	7.7 Energy Trading Market Participants	208
	7.8 Speculation in the Oil Markets	214
	7.9 Speculation in the Electricity Markets	216
	7.10 Speculation in the Natural Gas Markets	217
	7.11 Chapter Wrap-Up	219
	References	219
	Chapter 8 Energy Portfolios	223
	8.1 Modern Portfolio Theory	224
	8.2 Energy Portfolio Management	228
	8.3 Optimization of Electricity Portfolios	229
	8.3.1 Case Study: Economic Load Dispatch of a Portfolio of Gas-fired Power Plants	231
	8.4 Optimization of Gas Portfolios	233
	8.5 Other Energy Portfolio Management Models	235
	8.6 Chapter Wrap-Up	235
	References	236
	Chapter 9 Hedging Nonlinear Payoffs Using Options: The Case of a New Subsidies Regime for Renewables	239
	9.1 Renewable Energy, Options Pricing, and Government Subsidies	241
	9.1.1 Power Assets Modeled as a Vanilla Call Option	242
	9.1.2 Strike Price of a Wind Turbine	243
	9.1.3 Levelized Cost Price of Electricity	243
	9.1.4 Wind Turbines’ Competitiveness on the Electricity Market	245
	9.2 Government Subsidies as a Stochastic Process	248
	9.3 Impact of Embedded Options and Stochastic Subsidies on Pricing and Risk Management	251
	9.3.1 Pricing of a Wind Turbine and Subsidies as an Embedded Option	251
	9.3.2 Tail Risk and Hedging Options with Options	254
	9.4 Chapter Wrap-Up	256
	References	257
	Chapter 10 Case Study: Hydro Power Generation and Behavioral Finance in the U.S. Pacific Northwest	259
	10.1 An Overview of Behavioral Finance	261
	10.2 Behavioral Finance in Energy Economics	263
	10.3 Power Generation in the Pacific Northwest	264
	10.4 Behavioral Financing of Projects in the Pacific Northwest	267
	10.5 Northwest Power Planning	271
	10.5.1 Resource Availability	271
	10.5.2 Resource Cost	271
	10.5.3 System Flexibility	272
	10.5.4 Cost Effectiveness	273
	10.5.5 Transmission	273
	10.6 Chapter Wrap-Up	273
	Reference	274
	Bibliography	275
	Index	291