CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

28.2 MEASURING EVENT RISKS

Event risk, defined as a catastrophic unforeseen event, often leads to unusual market anomalies. One of these anomalies, seen during Hurricane Katrina, was the breakdown of intercommodity correlations. Basic economic relationships between commodities, for example, crude oil prices and refined oil prices (crude is a major input to the refinery process), ensure that certain commodity markets generally correlate with each other. Similarly, one would expect power and natural gas to be closely correlated, since natural gas fuels power plants. But after Hurricane Katrina, natural gas prices, which usually move in tandem with power prices, became less correlated. The effect of this type of event is illustrated in the following example.

In the oil market, a crack spread is the profit earned by a refiner for processing crude oil into diesel fuel or gasoline. In the electricity market, the spark spread is the profit earned by a power plant operator for generating electricity from natural gas. Assume that a fund had a short position on 500 MW/hour spark spreads between PJM Western Hub and NYMEX Henry Hub on August 26, 2005 (three days before Hurricane Katrina hit the Gulf). This position, with a $13 million notional, would require a 10% margin (i.e., economic capital), equal to $1.3 million in cash investments. Because Hurricane Katrina caused an unusual breakdown in the NYMEX natural gas and PJM power price correlation for a few days around August 29, 2005, the ...