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Handbook of Multi-Commodity Markets and Products: Structuring, Trading and Risk Management

ISBN: 978-0-470-74524-3
1064 pages
April 2015
Handbook of Multi-Commodity Markets and Products: Structuring, Trading and Risk Management (047074524X) cover image


The comprehensive guide to working more effectively within the multi-commodity market.

The Handbook of Multi-Commodity Markets and Products is the definitive desktop reference for traders, structurers, and risk managers who wish to broaden their knowledge base. This non-technical yet sophisticated manual covers everything the professional needs to become acquainted with the structure, function, rules, and practices across a wide spectrum of commodity markets. Contributions from a global team of renowned industry experts provide real-world examples for each market, along with tools for analyzing, pricing, and risk managing deals. The discussion focuses on convergence, including arbitrage valuation, econometric modeling, market structure analysis, contract engineering, and risk, while simulated scenarios help readers understand the practical application of the methods and models presented.

Gradual deregulation and the resulting increase in diversity and activity have driven the evolution of the traditionally segmented market toward integration, raising important questions about opportunity identification and analysis in multi-commodity deals. This book helps professionals navigate the shift, providing in-depth information and practical advice.

  • Structure and manage both simple and sophisticated multi-commodity deals
  • Exploit pay-off profiles and trading strategies with a diversified set of commodity prices
  • Develop more accurate forecasting models by considering additional metrics
  • Price energy products and other commodities in segmented markets with an eye toward specific structural features

As one of the only markets strong enough to boom during the credit crunch, the commodities markets are growing rapidly. Combined with increasing convergence, this transition presents potentially valuable opportunities for the development of a robust multi-commodity portfolio. For the professional seeking deeper understanding and a more effective strategy, the Handbook of Multi-Commodity Markets and Products offers complete information and expert guidance.

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Table of Contents

Preface xix

Acknowledgements xxiii

About the Editors xxv

List of Contributors xxvii

PART ONE Commodity Markets and Products

CHAPTER 1 Oil Markets and Products 3
Cristiano Campi and Francesco Galdenzi

1.1 Introduction 3

1.2 Risk Management for Corporations: Hedging Using Derivative Instruments 4

1.2.1 Crude Oil and Oil Products Risk Management for Corporations 4

1.3 Oil Physical Market Hedging and Trading 41

Further Reading 66

CHAPTER 2 Coal Markets and Products 67
Lars Schernikau

2.1 Introduction 67

2.2 Source of Coal – Synopsis of the Resource Coal 72

2.3 Use of Coal – Power Generation and More 90

2.4 Overview of Worldwide Steam Coal Supply and Demand 102

2.5 The Global Steam Coal Trade Market and its Future 121

2.6 Concluding Words 129

Abbreviations and Definitions 130

Acknowledgements 132

References 132

CHAPTER 3 Natural Gas Markets and Products 135
Mark Cummins and Bernard Murphy

3.1 Physical Natural Gas Markets 135

3.2 Natural Gas Contracting and Pricing 154

3.3 Financial Natural Gas Markets 158

References 180

CHAPTER 4 Electricity Markets and Products 181
Stefano Fiorenzani, Bernard Murphy and Mark Cummins

4.1 Market Structure and Price Components 181

4.2 Renewables, Intra-Day Trading and Capacity Markets 205

4.3 Risk Measures for Power Portfolios 216

References 221

Further Reading 221

CHAPTER 5 Emissions Markets and Products 223
Marc Chesney, Luca Taschini and Jonathan Gheyssens

5.1 Introduction 223

5.2 Climate Change and the Economics of Externalities 224

5.3 The Kyoto Protocol 227

5.4 The EU ETS 232

5.5 Regional Markets: A Fragmented Landscape 239

5.6 A New Asset Class: CO2 Emission Permits 241

Abbreviations 252

References 252

CHAPTER 6 Weather Risk and Weather Derivatives 255
Alessandro Mauro

6.1 Introduction 255

6.2 Identification of Volumetric Risk 257

6.3 Atmospheric Temperature and Natural Gas Market 264

6.4 Modification of Weather Risk Exposure with Weather Derivatives 272

6.5 Conclusions 276

Nomenclature 277

References 277

CHAPTER 7 Industrial Metals Markets and Products 279
Alessandro Porru

7.1 General Overview 279

7.2 Forward Curves 305

7.3 Volatility 337

Acknowledgements 352

References 353

Further Reading 353

CHAPTER 8 Freight Markets and Products 355
Manolis G. Kavussanos, Ilias D. Visvikis and Dimitris N. Dimitrakopoulos

8.1 Introduction 355

8.2 Business Risks in Shipping 356

8.3 Freight Rate Derivatives 366

8.4 Pricing, Hedging and Freight Rate Risk Measurement 382

8.5 Other Derivatives for the Shipping Industry 393

8.6 Conclusion 396

Acknowledgements 396

References 397

CHAPTER 9 Agricultural and Soft Markets 399
Francis Declerk

9.1 Introduction: Stakes and Objectives 399

9.2 Agricultural Commodity Specificity and Futures Markets 400

9.3 Demand and Supply, Price Determinants and Dynamics 409

9.4 Hedging and Basis Management 466

9.5 The Financialization of Agricultural Markets and Hunger: Speculation and Regulation 480

9.6 Conclusion about Hedging and Futures Contracts 493

References 495

Further Reading 496

Glossary, Quotations and Policy on Websites 497

CHAPTER 10 Foreign Exchange Markets and Products 499
Antonio Castagna

10.1 The FX Market 499

10.2 Pricing Models for FX Options 509

10.3 The Volatility Surface 511

10.4 Barrier Options 512

10.5 Sources of FX Risk Exposure 513

10.6 Hedging FX Exposures Embedded in Energy and Commodity Contracts 517

10.7 Typical Hedging Structures for FX Risk Exposure 533

References 553

PART TWO Quantitative Topics

CHAPTER 11 An Introduction to Stochastic Calculus with Matlab Examples 557
Laura Ballotta and Gianluca Fusai

11.1 Brownian Motion 558

11.2 The Stochastic Integral and Stochastic Differential Equations 566

11.3 Introducing Itˆo’s Formula 575

11.4 Important SDEs 581

11.5 Stochastic Processes with Jumps 618

References 633

Further Reading 633

CHAPTER 12 Estimating Commodity Term Structure Volatilities 635
Andrea Roncoroni, Rachid Id Brik and Mark Cummins

12.1 Introduction 635

12.2 Model Estimation Using the Kalman Filter 635

12.3 Principal Components Analysis 646

12.4 Conclusion 655

Appendix 655

References 657

CHAPTER 13 Nonparametric Estimation of Energy and Commodity Price Processes 659
Gianna Figà-Talamanca and Andrea Roncoroni

13.1 Introduction 659

13.2 Estimation Method 660

13.3 Empirical Results 663

References 672

CHAPTER 14 How to Build Electricity Forward Curves 673
Ruggero Caldana, Gianluca Fusai and Andrea Roncoroni

14.1 Introduction 673

14.2 Review of the Literature 674

14.3 Electricity Forward Contracts 675

14.4 Smoothing Forward Price Curves 677

14.5 An Illustrative Example: Daily Forward Curve 679

14.6 Conclusion 684

References 684

CHAPTER 15 GARCH Models for Commodity Markets 687
Eduardo Rossi and Filippo Spazzini

15.1 Introduction 687

15.2 The GARCH Model: General Definition 690

15.3 The IGARCH(p,q) Model 699

15.4 A Permanent and Transitory Component Model of Volatility 700

15.5 Asymmetric Models 702

15.6 Periodic GARCH 707

15.7 Nesting Models 708

15.8 Long-Memory GARCH Models 713

15.9 Estimation 720

15.10 Inference 722

15.11 Multivariate GARCH 725

15.12 Empirical Applications 727

15.13 Software 740

References 748

CHAPTER 16 Pricing Commodity Swaps with Counterparty Credit Risk: The Case of Credit Value Adjustment 755
Marina Marena, Gianluca Fusai and Chiara Quaglini

16.1 Introduction 755

16.2 Company Energy Policy 756

16.3 A Focus on Commodity Swap Contracts 758

16.4 Modelling the Dynamics of Oil Spot Prices and the Forward Curve 760

16.5 An Empirical Application 764

16.6 Measuring Counterparty Risk 777

16.7 Sensitivity Analysis 788

16.8 Accounting for Derivatives and Credit Value Adjustments 788

16.9 Conclusions 797

References 798

Further Reading 798

CHAPTER 17 Pricing Energy Spread Options 801
Fred Espen Benth and Hanna Zdanowicz

17.1 Spread Options in Energy Markets 801

17.2 Pricing of Spread Options with Zero Strike 805

17.3 Issues of hedging 813

17.4 Pricing of Spread Options with Nonzero Strike 815

Acknowledgement 824

References 825

CHAPTER 18 Asian Options: Payoffs and Pricing Models 827
Gianluca Fusai, Marina Marena and Giovanni Longo

18.1 Payoff Structures 832

18.2 Pricing Asian Options in the Lognormal Setting 833

18.3 A Comparison 856

18.4 The Flexible Square-Root Model 858

18.5 Conclusions 874

References 874

CHAPTER 19 Natural Gas Storage Modelling 877
Álvaro Cartea, James Cheeseman and Sebastian Jaimungal

19.1 Introduction 877

19.2 A Simple Model of Storage, Futures Prices, Spot Prices And Convenience Yield 878

19.3 Valuation of Gas Storage 880

References 899

CHAPTER 20 Commodity-Linked Arbitrage Strategies and Portfolio Management 901
Viviana Fanelli

20.1 Commodity-Linked Arbitrage Strategies 902

20.2 Portfolio Optimization with Commodities 921

Symbols 936

References 936

CHAPTER 21 Econometric Analysis of Energy and Commodity Markets: Multiple Hypothesis Testing Techniques 939
Mark Cummins

21.1 Introduction 939

21.2 Multiple Hypothesis Testing 940

21.3 Energy–Emissions Market Interactions 943

21.4 Emissions Market Interactions 953

21.5 Quantitative Spread Trading in Oil Markets 956

References 964


A Quick Review of Distributions Relevant in Finance with Matlab Examples 967
Laura Ballotta and Gianluca Fusai


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Author Information

ANDREA RONCORONI is Professor of Finance at ESSEC Business School (Paris-Singapore), regular Visiting Professor at Bocconi University (Milan), and Director of the ESSEC Energy and Commodity Finance research center. He holds PhD's in Applied Mathematics and in Finance. His research interests primarily cover energy and commodity markets, corporate financial risk analysis and management, quantitative modelling, derivative design and valuation. Andrea put forward the Threshold Model for price simulation in spiky electricity markets, and devised FloRisk Metrics, an effective analytics to monitor and manage corporate financial exposure. He publishes in academic journals, professional reviews, financial book series, and acts as Associate Editor for the Journal of Energy Markets and Co-Editor for Argo Review. Andrea has co-authored the reference volume Implementing Models in Quantitative Finance. As a professional advisor, he consulted for private companies and public institutions, including Dong Energy, Edison, Enel, GDF, Natixis, and Trafigura Electricity Italia (TEI Energy). He is founder and CEO of Energisk, a start-up company developing cutting-edge risk analytics for corporate clients.

GIANLUCA FUSAI is Full Professor in Financial Mathematics at the University of Eastern Piedmont, Italy, and a PT Reader in Mathematical Finance at Cass Business School, City University of London, UK. He holds a PhD in Finance from Warwick Business School, an MSc in Statistics and Operational Research from the University of Essex and a BSc in Economics from Bocconi University. His research interests focus on Energy Markets, Financial Engineering, Numerical Methods for Finance, Quantitative Risk Management. He has published extensively on these topics in top-tier international reviews. Gianluca has also co-authored the best-selling textbook Implementing Models in Quantitative Finance. Gianluca has cooperated to several projects in energy markets including a multi-energy risk assessment tool developed in conjunction with a pool of energy and industrial companies and a forward curve builder for the power and gas markets nowadays used for trading and marking to market. He has also been a consultant for private and public sector on building pricing tools of derivative products. Gianluca has been an expert witness in several derivative disputes.

MARK CUMMINS is Senior Lecturer in Finance at the Dublin City University Business School and holds a PhD in Quantitative Finance. Mark's research interests include a broad range of energy and commodity modelling, derivatives, risk management and trading topics. Mark has published in international journals such as Energy Economics, Applied Energy and the Journal of Energy Markets, as well as mainstream finance journals such as the Journal of Financial Markets, International Review of Financial Analysis and Quantitative Finance. Mark has previous industry experience working as a Quantitative Analyst within the Global Risk function for BP Oil International Ltd. As part of the Risk Quantitative Analysis team, primary responsibilities included derivatives and price curve model validation and development, with a global remit across BP's energy and commodity activities. Mark is engaged in ongoing industry training and consultancy activities, focused on the energy sector primarily.

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