Futures Equivalent Positions & Risk Curves
We introduce and compare some of the most common energy and commodity derivatives exposure aggregation methods used for hedging, risk management and regulatory reporting compliance.
By Carlos Blanco & Michael Pierce
MEASURING AND HEDGING market, liquidity and credit risk exposures of energy derivative portfolios often requires the use of precise exposure aggregation methods in order to create replicating portfolios that mimic the risk of the original exposures. New regulatory reporting requirements such as the Dodd-Frank Act (DF) also require the aggregation of individual exposures into futures equivalent positions to report and keep records of swap transactions. The main idea behind the calculation of futures
equivalent portfolios is to reproduce the economic exposure of changes in physical assets and contracts as well as the derivatives book using a hypothetical portfolio of futures contracts. For example, if we want to hedge the market risk of set of physical and financial exposures, we can estimate the number of futures contract that would be required to offset the market risk exposures using the replicating portfolio. The most common methodologies and main applications to represent the exposures of a physical or a derivatives contract as a synthetic portfolio of futures equivalent positions (FEPs) are summarized in Table 1.
1. Hedge Ratios or ‘Risk Curves’ The hedge ratios or ‘risk curve’ of a
physical or financial exposure represent the sensitivity of changes in its fair value versus changes in each forward price in the curve. At the portfolio level, risk curves show the sensitivity of the portfolio P&L versus changes in each reference forward price. For example, a swap contract with
Traders and risk managers can use hedge ratios to make a portfolio ‘market-neutral’ using the futures market by offsetting the exposures to the various points in the forward curve. Another common use of hedge ratios is to
compute ‘at-Risk’ calculations such as Value-at- Risk or Earnings-at-Risk. Once each contract is broken down into its individual risk sources, we can compute various market, credit and liquidity risk metrics as long as we can model the potential variability of those risk drivers. One of the key issues to take into account when calculating risk curves for energy and commodity OTC swaps is that many of those derivatives are Asian swaps (e.g. based on average prices of the underlying) due to the fact that they are used to hedge physical contracts with ratable delivery and average pricing terms. Commodity swaps are structured based on a wide range of underlying prices such as a spot price, a month-ahead index, or a given futures contract (e.g. prompt or deferred futures prices). The main practical implication is that the hedge strategy will depend on the formula used to determine which underlying price is used for the calculations of the floating leg.
Table 1: Common Aggregation Methods & Main Uses Method
Main Uses Hedge Ratios or Risk Curves
Hedging OTC swaps with futures. Market, credit and liquidity risk measurement. Risk charges.
Futures Equivalent Positions (FEP) Regulatory reporting purposes. CFTC position limits. Dodd Frank.
monthly settlements is exposed to each month of the forward curve that is used to calculate the floating leg payments of the swap. For basis instruments such as locational swaps, crack spread or spark spread swaps, the hedge ratios can be calculated for each leg of the spread or the actual forward basis curve. In the case of options and non- linear instruments, the hedge ratios are calculated by multiplying the notional times the delta of the contracts. The delta of an option is the first order sensitivity of the change of the option premium vs. changes in a given underlying forward price.
Front-Month Equivalent (FME)
High level single hedge exposures. Risk charges.
For example, a calendar-year swap with
monthly settlements referenced to the average of the first nearby futures contract during a given window could be represented as a strip of futures contracts with exposure quantities equivalent to the cumulative weights of each underlying contract in calculating the floating legs of the swap. Each swap settlement would therefore have exposure to more than one futures price. In addition, as the fixings that determine the average price become
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