Subject: preface for book
vince ,
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hope you are well .
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we spoke a while ago about who should write the preface for the book , and
you kindly offered that you would provide this . ? is this still possible ? ? we
realise that you are extremely busy , so chris and les went ahead and wrote
something , which is below , and if you want to review , change or re - write ? the
preface , that would be very appreciated . ? let me know what your thoughts are .
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thanks ,
julie
( we ' re getting close )
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preface
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one of our main objectives in writing energy derivatives : pricing and risk
management has been to bring together as many of the various approaches for
the pricing and risk management energy derivatives as possible , to discuss
in - depth the models , and to show how they relate to each other . ? in this
way we hope to help the reader to analyse the different models , price a wide
range of energy derivatives , or to build a risk management system which uses
a consistent modelling framework . ? we believe that for practitioners this
last point is very important and we continue to stress in our articles and
presentations the dangers of having flawed risk management and giving
arbitrage opportunities to your competitors by using ad - hoc and inconsistent
models for different instruments and markets ( see also others who propose
consistent models ? ) . ? however , it is not our wish to concentrate on one
particular model or models , at the exclusion of the others because we
believe that the choice should rest with the user ( although it will probably
be clear from our discussions the model ( s ) we prefer ) . ? we therefore try and
give as clear account as possible of the advantage and disadvantages of all
the models so that the reader can make an informed choice as to the models
which best suit their needs .
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in order to meet our objectives the book is divided into 11 chapters . ? in
chapter 1 we give an overview of the fundamental principals needed to model
and price energy derivatives which will underpin the remainder of the book . ?
in addition to introducing the techniques that underlie the black - scholes
modelling framework we outline the numerical techniques of trinomial trees
and monte carlo simulation for derivative pricing , which are used throughout
the book .
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in chapter 2 we discuss the analysis of spot energy prices . ? as well as
analysing empirical price movements we propose a number of processes that
can be used to model the prices . ? we look at the well - know process of
geometric brownian motion as well as mean reversion , stochastic volatility
and jump processes , discussing each and showing how they can be simulated
and their parameters estimated .
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chapter 3 , written by vince kaminski , grant masson and ronnie chahal of
enron corp . , discusses volatility estimation in energy commodity markets . ?
this chapter builds on the previous one . ? it examines in detail the methods ,
merits and pitfalls of the volatility estimation process assuming different
pricing models introduced in chapter 2 . ? examples from crude , gas , and
electricity markets are used to illustrate the technical and interpretative
aspects of calculating volatility .
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chapter 4 examines forward curves in the energy markets . ? although such
curves are well understood and straight - forward in the most financial
markets , the difficulty of storage in many energy markets leads to less well
defined curves . ? in this chapter we describe forward price bounds for energy
prices and the building of forward curves from market instruments . ? we
outline the three main approaches which have been applied to building
forward curves in energy markets ; the arbitrage approach , the econometric
approach , and deriving analytical values by modelling underlying stochastic
factors .
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chapter 5 presents an overview of structures found in the energy derivative
markets and discusses their uses . ? examples of products analysed in this
chapter include a variety of swaps , caps , floors and collars , as well as
energy swaptions , compound options , asian options , barrier options , lookback
options , and ladder options .
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chapter 6 investigates single and multi - factor models of the energy spot
price and the pricing of some standard energy derivatives . ? closed form
solutions for forward prices , forward volatilities , and european option
prices both on the spot and forwards are derived and presented for all the
models in this chapter including a three factor , stochastic convenience
yield and interest rate model .
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chapter 7 shows how the prices of path dependent and american style options
can be evaluated for the models in chapter 6 . ? simulation schemes are
developed for the evaluation of european style options and applied to a
variety of path dependent options . ? in order to price options which
incorporate early exercise opportunities , a trinomial tree scheme is
developed . ? this tree is built to be consistent with the observed forward
curve and can be used to price exotic as well as standard european and
american style options .
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chapter 8 describes a methodology for valuing energy options based on
modelling the whole of the market observed forward curve . ? the approach
results in a multi - factor model that is able to realistically capture the
evolution of a wide range of energy forward curves . ? the user defined
volatility structures can be of an extremely general form . ? closed - form
solutions are developed for pricing standard european options , and efficient
monte carlo schemes are presented for pricing exotic options . ? the chapter
closes with a discussion of the valuation of american style options .
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chapter 9 focuses on the risk management of energy derivative positions . ?
in this chapter we discuss the management of price risk for institutions
that trade options or other derivatives and who are then faced with the
problem of managing the risk through time . ? we begin with delta hedging a
portfolio containing derivatives and look at extensions to gamma hedging  )
illustrating the techniques using both spot and forward curve models . ? the
general model presented in chapter 8 is ideally suited to multi - factor
hedging of a portfolio of energy derivatives and this is also discussed .
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chapter 10 examines the key risk management concept of value at risk ( var )
applied to portfolios containing energy derivative products . ? after
discussing the concept of the measure , we look at how the key inputs
( volatilities , covariances , correlations , etc ) can be estimated . ? we then
compare the fours major methodologies for computing var ; delta , delta - gamma ,
historical simulation and monte - carlo simulation , applying each to the same
portfolio of energy options . ? in this chapter we also look at testing the
var estimates for various underlying energy market variables .
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finally , in chapter 11 we review modelling approaches to credit risk . ? we
look in detail at two quite different approaches , creditmetrics ( j . p . morgan
( 1997 ) ) and creditrisk + ( credit suisse financial products ( 1997 ) ) for which
detailed information is publicly available . ? together these provide an
extensive set of tools with which to measure credit risk . ? we present
numerical examples of applying these techniques to energy derivatives .
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before we begin we stress that the models and methods we present in this
book are tools which should be used with the benefit of an understanding of
how both the  + tool  , and the market works . ? the techniques we describe are
certainly not  & magic wands  8 which can be waved at data and risk management
problems to provide instant and perfect solutions . ? to quote from the
riskmetrics technical document  &  ( no amount of sophisticated analytics will
replace experience and professional judgement in managing risk .  8 . ? however ,
the right tools , correctly used make the job a lot easier !