PRE-TRADE RISK ANALYTICS
below the limit. John sends Anne an IM “thanks for all your help” A few days later, Jenn, a new gas trader,
finds herself in a similar situation. Her book is about to breach her VaR limit of $50,000. She asks Anne for advice on how to reduce the VaR of her book but she just gives her a similar response as the one she gave John a few days before. Jenn then asks John if he can help her manage her VaR limit, and he tells her about the Trade Risk Profile and Best Hedge report that he has been using regularly for a few weeks. It is a slow day in the gas markets, so John has time to explain her how to set up the spreadsheet and interpret the model output. Before the market close, Jenn enters her
Figure 3: Trade Risk Profile For Jenn’s Trading Book Trade Risk Profile
$10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000 $80,000 $90,000
$- (900,000) (800,000) (700,000) (600,000) (500,000) (400,000) (300,000) (200,000) (100,000) Henry Hub Position (MMBTUs) Source: NQuantX
positions and volatility and correlation information in the spreadsheet that John gave her, and she generates the report in Table 3 and Figure 3. She notices that the VaR of her book could be brought from $48,809 down to $31,764 by reducing her short exposure to Natural Gas Henry Hub. The risk management action to minimize VaR is to go long 22 NYMEX April 2013 contracts. The new net long position would be of 38 contracts instead of the original 60 lots. The trade risk profile in Figure 3 also shows that
if Jenn were to overhedge and liquidate the short Henry Hub position, her VaR would increase to approximately $70,000 from the original $48,809. Jenn may end up deciding to conduct other
adjustments to the book, but now she knows the implications of new trades from a pure VaR reduction perspective. She still has 15 minutes before the market is closed for the day.
Summary We have shown how to enhance traditional volume and dollar exposure reports using implied risk views and marginal risk contributions. The implementation of these tools can allow traders and risk managers work closer together in proactively managing VaR
Carlos Blanco is co-founder and managing director of NQuantX, LLC (
carlos@nquantx.com), a financial engineering firm that develops customized software to design and implement hedging programs as
well as valuation and risk measurement of energy derivatives, long term contracts and physical
assets. He also conducts several courses on energy derivatives hedging, pricing and risk management, gas and power trading, as well as liquidity and counterparty risk management for the Oxford- Princeton Programme:
www.oxfordprinceton.com www.nquantx.com
Table 3: Best Hedge Report for Jenn’s Trading Book Existing VaR
VaR Limit
Minimum VaR VaR Reduction Existing Hedge Best Hedge Adjustment
Optimal VaR Action Source: NQuantX
$ 48,809 $ 50,000 $ 31,764 $ 17,044 (600,000) (380,000) 220,000
Long 22 NYMEX April 2013 Contracts
limits, maximizing risk adjusted performance and reverse engineering the portfolio dynamics. Tools such as Best hedge reports and trade risk
profiles as well as the implied risk views and marginal risk contributions can significantly enhance traditional volume and dollar exposure reports. In addition they can provide a guide to action to traders that need to manage the VaR of their books and turn passive into active risk management. These tools can be directly accessed by traders from
a spreadsheet for maximum flexibility and real-time management of VaR limits and complement existing ETRM systems which tend to produce VaR numbers based on end of day positions and market prices. •
Footnote:
1. Value at Risk is a measure of the maximum losses a portfolio may experience for a confidence level over a given time horizon. For example, if our portfolio VaR is $100,000 for a 95% confidence level and 1 day horizon, there is a 5% chance that we may lose more than $100,000 over the next 24 hours.
References:
“Hot Spots and Hedges” Litterman, R. Journal of Portfolio Management. 1996.
“VaR and p&l decomposition, part III.” Carlos Blanco. Energy Metro Desk. October 29th , 2012.
“Beyond VaR: From Measuring Risk to Managing Risk” Mausser, H. and Rosen D. Algorithmics Research Quarterly 1998.
March 2013 55 - 100,000 200,000 • • •
MMBTUs MMBTUs MMBTUs
Portfolio VaR
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