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EnergyTrading&RiskManagement
The current financial crisis has exposed a cloud around derivatives structures and the profit and
lossimplicationsofusingderivativeinstrumentsandotherexoticfinancialstructures.However,this
lack of understanding was not limited to mortgages and prevails across all asset classes. This is
particularlytrueofthecommodityderivativesmarketplace.
By Guy Isherwood
W
hile banks and other financial institutions made a considerably depending on which commodities are traded,
thriving business out of structured products there what assets are employed in the business, where those assets
was a lack of transparency about the models and are located, and what the company’s business strategy and
data used for the pricing and valuation of such instruments. associatedbusinessprocessesare.
Overtime,derivativeshavebecomemoreandmoreexoticand Recently, the market for ETRM software has become more
have been designed to suit the risk appetite of a more diverse buoyant once again. It rebounded significantly as hedge
bandofcustomers.Andmanyoftheseinstitutionshaveclearly funds,proprietarytradersandinvestmentbankshaveentered
used structures wholly inappropriate to their operations. themarketwhileEuropeanderegulationhasalsohelpedfoster
Corporations and utilities, whose original risk management theexplosivegrowthinenergyandothercommoditiestrading
functionwastohedgetheircommoditymarketrisk,oftenface over the last 4-5 years. UtiliPoint International research
the challenge of selecting the right structures to hedge, price, indicates growth rates for ETRM software in North America
value,andmanagetherisksoncetheyexecutehedges. and Europe at 15% in recent years. After the recent lull in
Hedgingisaconsciousdecision.Corporationsthatconsume activity, more and more companies are directing their
or produce commodities have a need to hedge their exposure attentiontoT&RMsystemsonceagain.Onetrendrightnowis
to price risk due to changes in commodity prices. This is very to move toward commodity trading and risk management
important in volatile times as now. It is equally true in software–replacingthe‘E’inETRMwitha‘C’.
‘normal’ times as the mean-reverting Additionally, the maturing of electronic
commodities markets are one of the world’s
...more&more
marketplaces such as ICE and CME
most volatile assets classes. For holders of
companiesaredirecting
Group/NYMEXhasalsoreducedmanyofthe
assets,theobjectiveofhedgingistosecurea
certain price level for the commodity
theirattentiontoT&RM
barriers to entry for those wishing to trade
commodities with the expansion of the
consumed or produced and/or avoid
systemsonceagain
numberandtypeofinstrumentstotradehas
catastrophic losses in the event of markets fuelledthisgrowth.
movinginthe‘wrong’direction.Mostoften,theneedtosecure Another aspect of the growth in ETRM/CTRM software
pricelevelsarisesduetothefactthatpricefluctuationscannot markets has also been simply that, overall, the requirements
bepassedontocustomersintoday’scompetitiveenvironment. have changed and, particularly in North America,
Even if such fluctuations can be passed on to customers, the replacementsofolderETRMsolutionshastakenplace.Infact,
effectwillbereducedconsumption,atleastintheshort-term. the changes that Utilipoint have observed in commodity
Thismeansthattheimpactofunfavourablecommodityprices marketsingeneral(andenergycommoditiesinparticular)are
has to be absorbed by the corporation, so there is a definite helpingtodrivefundamentalchangesinbothtradingandrisk
downsidetonotprotectingthepricelevelsofcommodities. management practice and in the requirements for T&RM
Therefore, in the absence of a clear objective, many software – particularly with credit and regulatory risk
corporations forget (more often than not) that the purpose of becomingparamountintoday'stradingenvironment.
hedging using commodity derivative instruments is to protect Notwithstandingtherecentdeclineintradingforanumber
against the market risk of commodity prices going against ofenergycommodities,overall,therehasbeenanincreasein
themandnotforprofitingfromthehedges.Andinalmostall traded volumes through an increase in the number of
instances, after the hedges are executed, there is further need instruments, exchanges and traders – a growing financial
todynamicallymanagethesehedgepositions.Forexample,a aspect to commodity trading, with larger and more erratic
power generation company with several power plants might price swings. Increasingly, commodity price movements have
need to secure the availability of physical coal for running hadveterantradersfooledandlookingforrhymeorreasonto
plant at budgeted prices over a period of time to ensure their explain market events. And one characteristic of today’s
operatingmarginsandgrowth. commodity markets that must not be overlooked is the fact
Recent market volatility has created a growing demand for thattheyarenowafully-fledgedassetclassintheirownright.
energy trading and risk management (ETRM) systems – the
categoryofsoftwareapplications,architechturesandtoolsthat Impacts on Commodity Trading & Traders
support the business processes associated with the trading of Atthehighestlevel,therearethreemajorimpactsofallthis
energy commodities. Not surprisingly, ETRM software suites in terms of trading and risk management. The first major
tendtocompriseaverycomplexsetoffunctionalitiesthatvary change,observedbyUtiliPointInternational,isthat,unlikea
36 worldPower2009
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