ForwardCurve

Slide 1: 

Building the Forward Curve Concepts & Methodology Return to Risk Limited website: www.RiskLimited.com

Forward Curve Significance : 

Forward Curve Significance Forward Curve Development Is Crucially Important To Market Development No Trades Without One Obviously Important To A Firm’s Forward Trading, Pricing And Hedging Activity Lots Of Money At Stake In Emerging Market Trading

Forward Curve Significance : 

Forward Curve Significance Need Forward Curve Before Options Market Can Develop Fundamental Necessary Step Basis For Volatility Analysis Fixed Forward Pricing

Requirements For A Forward Market : 

Requirements For A Forward Market Size Of Physical Market Minimum Volume In Underlying Physical Spot Trading Spot Price Must Exhibit Some Degree Of Volatility Coal Market In Prior Times Did Not Meet The Conditions Needed For Forward Market To Develop

Sophistication Of The Market : 

Sophistication Of The Market Financials Pricing Concepts Not In Terms Of Physical Operation Sophistication Practitioners And Academic

What Is The Forward Curve? : 

What Is The Forward Curve? Typical Definition Is… Forward Curve Is The Curve Representing The Prices At Which The Market Is Willing To Transact Future Business, Today.

What It Isn’t : 

What It Isn’t Forward Curve Is Not A Predictor Of Future Spot Prices Or Certainly Not A Good One As Shown By A Number Of Academic Studies Of Various Markets Such As Foreign Exchange

Availability Of Price Indicators : 

Availability Of Price Indicators In Liquid Traded Markets A Question Of Sourcing The Data Price Transparency Or Difficult Access For Outsiders Possibly Some Difficulty In Access, But Not A Problematic Modeling Or Mathematical Issue

Sourcing Market Data : 

Sourcing Market Data Lack Of Price Transparency Private Market Affect Standardization Of Transaction Hubs Or Index Points NG & Petrochemical Examples Survey Methods & Reporting US NG At Basis Points Other Than Henry Hub

Overcoming The Lack Of Data : 

Overcoming The Lack Of Data An Issue Faced In Each Emerging Market Common Problem, But… Not To Say It Is Easy Or Has A Standard Solution Degree Of Difficulty Posed Depends On Characteristics Of Each New Market

Historical Pricing : 

Historical Pricing Known Seasonality Pattern In Historical Pricing But What If There Are No Historical Prices Meaning, No Price History Of Spot Prices In Some Emerging Traded Markets, There Has Not Been Forward Physical Trading, No Futures, No OTC Forward Financials Like Swaps – But …

Historical Pricing : 

Historical Pricing If There Is A Known Price Series Of Historical Spot Prices Or Relevant Spot Prices Structural Change Of Market (NG) No Published Or Accessible Transaction Pricing (Steel)

Building The Curve : 

Building The Curve In New Or Illiquid Markets What Are The Alternatives For Building The Curve? Unfortunately, No Standard Or Easy Solutions

Building The Curve : 

Building The Curve Similar Need May Arise In Active Or Mature Markets For Development Of Long-Dated Pricing Curve Taking The Forward Out 5, 10, or 15 Years Typically, A Bit Less Problematic In That Spot And Short-Term Price Histories Exist Market Familiarity & Sophistication Exist

Emerging Market Examples : 

Emerging Market Examples Forward Curve Development Is A Concern In The Power Markets But Concept Is Not A New Issue Same Issue Arises In Every Emerging Market, By Definition

Emerging Market Examples : 

Emerging Market Examples For Example… US Natural Gas Market, 1991 Now Well Established 20 Year Curve Petrochemicals Market, 1997 Still Evolving, But Multi-Year Curve For Select Products

Emerging Market Examples : 

Emerging Market Examples Pulp (& Paper) Market, 1994 Trading & Forward Pricing Development Has Languished For Other Structural Reasons Coal Market, 1999 Developing Rapidly Steel, 1995 Languished

Power Market Uniqueness : 

Power Market Uniqueness Special Complexities In Power Markets Such As US With Extreme Price Volatility Determining A Probable Range Is The Best Goal Not Absolute Precise Forward Curve, But Logical Range Model Output Best Not Treated As A Precise Point Estimate

Categories Of Modeling Approaches : 

Categories Of Modeling Approaches Cash & Carry Econometric Arbitrage Constrained Interpolation & Extrapolation Market Maker / Intuitive None Are Perfect, Precise, Or Easy, But… In Aggregate May Provide Range Boundary

Modeling Approaches – Cash & Carry : 

Modeling Approaches – Cash & Carry Simplistic Model Also Referred To As Cost Of Carry But Applicable In Some Physical Commodities & Financial Assets A Starting Point Not Directly Applicable In Power Because Electricity Is Not Storable

Modeling Approaches – Econometric : 

Modeling Approaches – Econometric Fundamentals Projections Supply / Demand Balance Current & Future Establishing Components In Supply & Demand Equation Modeling Factors Influencing These Components In The Future Poor Performance Record As A Predictor

Modeling Approaches – Arbitrage : 

Modeling Approaches – Arbitrage Between Prices Available For Future Dates On Different Markets Or Instruments Futures, Physical Forwards & Fixed Price Swaps Growth Of One Market Or Instrument Can Support Another In Price Discovery Value Of Having Futures Markets With High Transparency To Support OTC Swaps Development

Modeling Approaches – Interpolation & Extrapolation : 

Modeling Approaches – Interpolation & Extrapolation Uses Limited Number Of Known Forward Transaction Prices To Establish A Full Curve With Assumed Guidelines & Constraints, Such As Seasonal Pricing, Mean Reversion Perhaps Not As Sophisticated A Method, But Popular And Possibly Useful

Modeling Approaches – Market Maker Or Intuitive : 

Modeling Approaches – Market Maker Or Intuitive Specialized Participant Willing To Make Prices In Illiquid Markets May Be Intuitive Pricing Rather Than Mathematical Model Driven, But Effective If Exists Long-Term US Natural Gas Market Development

Econometric Modeling : 

Econometric Modeling All Factors Affecting Current Supply & Demand Should Determine The Current Price Spot Pricing Based On Supply/Demand Balance Absent Constraints Supply / Demand Balance At Some Future Time Point Should Determine Future Price If The S / D Factors Could Be Predicted

Econometric Modeling : 

Econometric Modeling The Forward Curve Is Not A Forecast It Is Not A Predictor Of Future Prices

Regulatory Considerations – Affecting Fundamentals : 

Regulatory Considerations – Affecting Fundamentals A Wild Card Driving Fundamentals Difficult To Predict Contributes To Uncertainty In Forward Pricing Predicting The Political Process How? When? Prior US Power Market Example

Econometric Modeling : 

Econometric Modeling Highlights The Weakness Of Econometric Approach – Uncertainty Of Inputs Even If An Accurate Deterministic Model Formula Can Be Constructed Running Of Deterministic Solutions With Different Scenario Inputs Or Distributions To Establish Probable Boundaries And Estimating Variability & Certainty

Arbitrage Modeling : 

Arbitrage Modeling Based On Correlation Of Market Prices Stability Of Correlations Correlations Tend To Break Down When You Need Them

Arbitrage Modeling : 

Arbitrage Modeling Based On Assumptions Regarding Correlations Between Markets And Stability Of That Correlation Level Does Not Necessarily Require That There Be A Perfect Price Correlation Petrochemical And US Power Examples

Arbitrage Modeling – US Power Example : 

Arbitrage Modeling – US Power Example A Primary Basis Of Pricing At Beginning Of US Wholesale Power Market Major Market Makers Were Enron & DLD From Financial, Not Physical Markets Side With Extensive Experience In Gas Trading The Presumed Spark Spread

Arbitrage Modeling – US Power Example : 

Arbitrage Modeling – US Power Example For Each Region Modeling Supply Curve Generation Mix Conversion Or Heat Rates Expected Participant Behaviors Likely Transmission Constraints Between Regions

Petrochemicals Forward Market Development : 

Petrochemicals Forward Market Development Huge Physical Market Lack Of Price Discovery Established Indices Concentration Of Market In Some Products On Both Supply And Consumption Fragmented Products But Standard Specifications

Arbitrage Modeling – Petrochemicals : 

Arbitrage Modeling – Petrochemicals Primary Basis Of Forward Pricing Petrochemicals Swaps Market Major Market Makers, Enron, Dreyfus & Morgan Stanley Econometrics Supply / Demand Modeling Quite Complex And Uncertain On Supply Side Surrogate Hedging With Ratios Of Oil Complex

US Natural Gas Evolution : 

US Natural Gas Evolution Futures Began Trading April 4, 1991 During Period Of Rising Price Volatility Over-The-Counter Market Trading Had Already Begun Demand High For Very Long-Term Hedge Instruments For NG Price Exposure On Project Finance [IPP’s]

Interpolation &Extrapolation : 

Interpolation &Extrapolation Basis Of Some Of The “Black Box” Models Offered By Some Firms Another Reference Point In Estimation Of A Probable Range Or Distribution Of Forward Prices

Interpolation &Extrapolation : 

Interpolation &Extrapolation Uses Scarce Number Of Known Transactable Forward Prices To Establish A Full Curve Presumption That Some Valid Data Points On Bid / Offer Are Known For Active Participants Likely That Some Few Select Transacted Deals Will Be Done Or Observed Past Normally Quoted Forward Curve Shows The Value Of Vigorous Market Information Gathering

Interpolation &Extrapolation : 

Interpolation &Extrapolation Extrapolation And / Or Interpolation Is Used With Imposed Constraints Provided By Model Supplier Or Input By User For Parameters Such As… Predicted Mean Reversion Level Observed Seasonality Of Prices Observed Relationship Of Volatility To Absolute Price Levels

Cash & Carry : 

Cash & Carry Cash And Carry Arbitrage Referring To Risk-Free Arbitrage Not “Spec’ing The Market” Indicates The Maximum For Forward Prices And Is Transactable To Drive The Market Pricing In Line Picking Up Dimes In Front Of Steamroller

Cash & Carry Factors : 

Cash & Carry Factors For Commodities, Cost Of Carry Typically Includes: Storage Charges & Input / Output Handling Fees Any Incremental Transportation To / From Storage Facilities Cost Of Funds Insurance, Taxes, & Any Other Logistics Fees

Cash & Carry Application : 

Cash & Carry Application Why Not Applicable For Power Markets? No Electricity Storage Available, Or At Least Not Meaningful Amounts Of Storage Even If Considering Pumped Storage Is Hydro Storage?

Cash & Carry – US Natural Gas Example : 

Cash & Carry – US Natural Gas Example Suppose The Spot Cash Market Price For Natural Gas Is US$ 2.00 / MMBtu And The Cost Of All Storage, Storage Related Fees, And Insurance Is US$ 0.25 / MMBtu Per Month The Yield On A 1-Month T-Bill Is 6% Then The Maximum Forward Price For The Same Location Point Should Be US$ 2.7625

Forward Curve Standard Shapes : 

Backwardation & Contango Why Would A Commodity Forward Curve Be Downward Sloping (In Backwardation)? Forward Curve Standard Shapes

Forward Curve Standard Shapes : 

Forward Curve Standard Shapes

Crude Oil Forwards Market : 

Crude Oil Forwards Market Why Is The Crude Oil Curve Typically In Backwardation? For Total US Market Consumption, Only A Few Days Of Total Storage Hence Market Is Willing To Pay A Prompt Premium What Would Swing Curve Into Contango?

Forward Curve Standard Shapes : 

Equivalents In Capital Markets Inverted & Normal Curves In Interest Rate Markets Forward Curve Standard Shapes

Market Maker Approach : 

Trader’s View On Indicated Forward Bid Offer Range Back-To-Back Capability Willingness To Make A Price Degree Of Difficulty, Degree Of Certainty Market Maker Approach

Market Makers : 

Market Makers Market Makers May Have Hedge Techniques Or Mechanisms Not Available To Others Which Allows Them To Take “Spec” Positions With Risk Profiles Unacceptable To Other Market Participants To Trade It, Need To Be Able To Price It And To Hedge It

Market Makers : 

Market Makers Existence Of Market Makers In A New Market To Establish A Clearing Price Two-Way Market, Bid / Ask Pricing “Any Deal At Some Price” “But You May Not Like The Price”

Testing Market : 

Testing Market Exploring Market For Forward Transactional Prices Bid / Offer Spreads Market Maker Technique Important Role Of Brokers As Intermediaries Providing Price Discovery

Cobalt Example : 

Cobalt Example Well Known Transactional Spot Pricing No Forwards, Futures, Swaps No Forward Transactional Activity Of Any Kind Highly Concentrated Market In Supply And Consumption Sides Extreme Instability In Supply Volatile Price

Cobalt Example : 

Cobalt Example Truly Undeveloped Forward Market But Valuable To Have Had Spot Price Histories Cost Of Production Average Prices In Stable Periods But Structural Changes Of The Market Bank Was In Unique Market Maker Role Profitability Exceptional

Conclusions : 

Conclusions Any Actual Transaction Pricing For Future Dates Is Valuable Input In Deciphering The Full Forward Curve Even If Differing Tenors Than Forward Time Point Most Of Interest To You Even If In A Different Instrument [Futures, OTC Fixed Price Swaps, Forward Physicals] Or From A Highly Correlated Market

Conclusions : 

Conclusions Other Prior Emerging Markets Offer Some Guide To Probable Directions For Power Curve Development But Unique Complexities In Power Pros & Cons For Each Of The Various Estimation Approaches And Techniques Best Used In Aggregate

Conclusions : 

Conclusions Recognize Model Output As Estimate, Not Absolutes Best Objective Is Projecting A Useable Range For The Forward Curve Considerable Resources In Quantitative Research And Trading Market Intelligence Need To Be Applied For Best Curve Development