FEPs & RISK CURVES
an instrument for the full forward curve based on our knowledge of changes in the prompt month as well as the relative level of prices, volatilities and correlations between the different points in the forward curve.
The calculation of the FME position is: N
FME =
Where: Hi
iΣ Ηi ρ1i – – s
= 1 σ1
σi si 1
is the volumetric position in the contract for the i−th month
ρ1i is the correlation between the prompt month and the i−th month
σi – – s1
σ1 si
is the relative level of volatilities between the i−th contract and the prompt month
is the relative level of prices between the i−th and the prompt month
Table 3: Sample Calculation of FME of 100 NYMEX Natural Gas Contracts Price
Jul-12 Jul-13 Ratios
$ 2.45 $ 2.85 116.3%
71.7% FME (%) 70.89% (71 contracts) For example, let’s assume that we are in June
2012 and have a long 100 NYMEX Henry Hub futures contracts for July 2013 delivery. Table
Carlos Blanco is Managing Director of NQuantX LLC (
carlos@nquantx.com), a financial engineering firm
that develops decision-support software for energy and commodity trading and hedging, as well as valuation
and risk measurement of derivatives, long term contracts and physical assets. He is a faculty member of the Oxford Princeton Programme, where he heads the Energy Derivatives Pricing, Hedging and Risk Management Certificate courses (DPH), as well as other courses on energy trading and risk management.
Michael Pierce is Director of Financial Engineering at NQuantX LLC and a former senior financial engineer with FEA, a BARRA company. He is the lead developer of NQuantX Global Commodity Workbench, a Microsoft
Excel-based product used for valuation and market, credit and liquidity risk management of commodity and energy swaps and options..
www.
nquantx.com 85%
3 shows the calculation of the FME ratio and equivalent contracts based on the relative level of prices, volatilities and correlation. In multi-commodity portfolios, FMEs can be used
to show an aggregate metric that represents the market risk exposure to each forward curve. FME positions can also be used to compute risk
capital metrics, bid-ask spread charges, as well as to determine how hedge a portfolio by using the most liquid contracts. However, due to the instability of
Dodd-Frank is likely to impact
most energy market participants using OTC swaps
volatilities and correlations amongst prices in the same curve, FME-based hedges must be used with caution. FME positions also have the problem that the full covariance matrix is not taken into account and therefore the risk representation of the portfolio may not be very accurate. Another limitation is that when the portfolio contains calendar spread positions, the FME approach is often insufficient to capture the risk of those trading strategies.
Volatility Correlation 53% 38%
Summary In summary, there are different ways of
aggregating market risk exposures, but the hedge ratio or ‘risk curve’ approach seems overall superior from a risk management perspective to the one devised by the CFTC or the single-metric based ones such as FMEs. The CFTC approach was not intended to replace risk curves or hedge ratios, but a strict implementation will force OTC market participants to calculate a new set of exposure metrics and reports exclusively to send to the CFTC with minimal added value to the risk management process of the firm. Dodd-Frank is likely to impact most energy market
participants using OTC swaps and risk groups are going to be required to dedicate significant resource to assist compliance teams to ensure that they meet the new rules and regulations. To avoid the regulatory and compliance burden imposed by DF, some firms that qualify as end users may move from OTC financial swaps to physically settled contracts such as fixed-price physical deals and physical deals with embedded optionality. •
References
1. “Front-Month Equivalent: Practical Uses for Proprietary Traders, Market Makers and Risk Managers”, Kiodex White Paper, 2004.
2. CFTC & Dodd-Frank rules (
www.cftc.gov/LawRegulation/ DoddFrankAct/
index.htm)
88
June 2012
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