Senior Structuring and Pricing Analyst
The Energy Authority®
Forward price models can be a critical component of the risk management framework. Despite the utility of forward price models, models of spot prices are far more prevalent in the energy industry. Yet, for most questions involving changes in portfolio value, only a model of forward prices provides meaningful results. In this chapter, a tractable model of forward prices with time-varying volatility is presented. Rather than attempt to fit volatility parameters for an entire forward curve, the model recognizes that each forward contract may exhibit unique volatility characteristics and error structure. Further, the model incorporates the interrelationship between contracts of the same commodity and across commodities and allows for temporal changes to these interrelationships.
The risk management process varies greatly from organization to organization, but regardless of whether it is simple or complex, the crucial first step is always the same. Before risk can be managed, risk must be quantified. Many different types of entities may buy or sell commodities futures contracts in order to hedge risk. An oil producer may sell a portion of its expected future production today to be delivered at some point in time. By selling at a known price for ...