Dark Energy Consulting

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General

Detailed Glossary

## Detailed Glossary

Risk |

## Cascading | ||
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The process of decomposing longer tenor Exchange traded derivatives (futures and swaps) contracts for the equivalent shorter contracts Detail Let's start with an example - a trader buys a futures contract for delivery for the whole of 2018, a so-called Cal-18 contract Every day that contract is available to trade, and the Exchange publishes a settlement price for that contract that determines daily margining At the time of trading (2014) the Exchange does not offer any other contracts covering 2018 - months or quarters for example At the end of 2017 the trader wants to keep the position open, but the Exchange can't continue to publish a Settlement price for the 2018 yearly contract because it can't be traded (the delivery period has already started) By this time the Exchange is offering Quarters contracts covering the whole of 2018, and Month contracts covering at least the first three months of 2018 So the Exchange, the Clearing broker and the trader all cascade the year contract into four quarterly contracts; Q1, Q2, Q3, Q4 2018. Q2, Q3 and Q4 are all still tradable, but the Q1 position needs to be closed out, or itself cascaded into three months, January, February and March As you've probably realized the January contract will very soon be untradable, so it needs to be - Closed out - the trader flattens his position in that contract
- Taken to or exchanged for an equivalent physical contract
- (for financial futures) taken into financial settlement
By cascading longer contracts into shorter contracts shortly before the longer contracts begin delivery the Exchange can effectively offer a small set of monthly, quarterly and yearly contracts, that have monthly granularity in the short term, but cover a period of years into the future As an example EEX are quoting the following Phelix Futures contracts at the time of writing (11 November 2014): - Months - usually current month + next nine months - November 2014 to August 2015
- Quarters - next eleven Quarters - Q1 2015 to Q3 2017
- Years - next six years - 2015 to 2020
(If you're wondering why November 2014 is still being quoted then that's because it is financially settled through the delivery month - the contract is not tradable in November) | ||

## Curve | ||
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Curve is a relatively general term to describe a set of time series data, for example prices, interest rates, foreign exchange rates (FX), volatilities etc. Detail In general curve is used as a term to describe time series data that is used to value trades, that is to calculate the unrealized p&l of a trade, or set of trades. Curve data is usually derived from published data Curve data is typically published each day - so a curve consists of a set of time series data for each publication date Publication dates are ususally daily Point dates may be daily, hourly, monthly, quarter hourly Because of the separate publication date and point date dimensions there may be a huge amount of data over time for a single curve A forward curve is usually a set of future price points used to calculate the future value of the physical side of Forwards, Futures, Spreads and Swaps Curves typically have dimensionality of: | ||

## Delta | ||
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At its simplest the delta of a trade or position is the ratio of its change in value to the change in value of its underlier Detail More accurately the delta is the ratio or sensitivity of the change in trade trade value to any variable, market value or observable For example a simple Physical Forward trade has a sensitivity to: - The price of the underlier
- The interest rate
- The FX rate of the currency it was executed in to our base reporting currency
So the delta is the ratio of the change in value of the trade per unit volume (e.g. €/MWh) to the change in value of a market value or underlier (e.g. the underlier power price quoted in €/MWh) to give a dimensionless ratio You may come across a use of Delta as the ratio of the change in total value of the trade (e.g. €) to the change in price of the underlier (e.g. €/MWh) to give a value with units of volume, in this case MWh. This definition of delta is usually referred to as the Exposure, and may also be thought of as the delta above multiplied by the volume The delta of fixed price Forwards and Futures is about one The delta of options varies between 0 and 1 (or -1 to +1) Exposures are additive - they can be summed across a set of trades or portfolios Deltas are not additive - because they are dimensionless ratios Delta is one of the Greeks - usually the most important Greek for trades with no optionality | ||

## Delta Hedge | ||
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To offset the delta of an option or other non-linear trade, usually with a linear derivatives position Detail If we buy a simple call option, or sell a simple put option, then we may or may not have a long position when the delivery date of the (potentially exercised) contract is made In reality the option will either get exercised or not - let's say the option is for the delivery of 1,000 MT of coal in January 2016 at ARA (Amsterdam Rotterdam Antwerp location) - we will either have a position of 1,000 MT at that time, or not On any particular day the option will have a calculable delta, which roughly translates into a probability of the option being exercised: An option with a delta of 0.01 has a 1% chance of being exercised An option with a delta of 0.5 has about a 50% chance of being exercised Traders generally hedge the exposure of the option (which is the delta times the volume), so if the delta is 0.5 they will hedge 500 MT of coal In general as the option exercise time approaches the delta of the option will swing quite rapidly toward 0 or 1 (or -1) so that the hedge swings toward 1,000 Mt or 0 MT If you're wondering why an option with a delta of 0.5 (meaning the value of each MT changes by €0.5 for each change in €1 per MT in the value of coal) has a 50% chance of being exercised then think the other way round - if the option was certain to be exercised then its value would change by €1 per MT per change of €1 per MT in the price of coal, so its delta would be one - the delta is effectively the probability of being exercised
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## Discounting | ||
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Calculation of the present day value of a cash flow that will or might occur at some time in the future Detail Suppose I offered to give you £1,000 right now - you'd be pretty pleased (wouldn't you?! If not imagine it's £10,000,000) Suppose I guarantee to give you £1,000 in one year's time - you'd also be pleased I guess, but less pleased of course... Why? Well, for starters if you got it today you could use right away Even if you wanted to use it in a year's time you'd rather have it now because you could put it in the bank and earn some interest over the next year Conversely, if you really needed some money now, you could borrow it from a bank and then repay it when I paid you in a year's time But if you borrowed £1,000 now you'd have to pay interest over the year, so you'd actually end up owing a bit more than £1,000, let's say £1,050 So if you worked out how much interest you would pay, and borrowed an amount, such that the initial amount plus the interest over the next year came to £1,000, then the £1,000 would exactly pay it off Let's say you did the calculation and it came out that you could borrow £965, the interest on that over the year coming to £35 We could then say that £1,000 in a year's time is equivalent to £965 right now We call that £965 the discounted value of the £1,000 in a year's time You can see that the general principle is the discounted value is worked back from the actual value from the expected payment date to today using the expected interest rates In order to calculate a discounted cash value we need: The payment date - usually available from the contract terms, or the master agreement The interest rate curve (for the payment currency or an alternative hedging currency) | ||

## Exposure | ||
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Exposure is the sensitivity of the value of a trade, or a portfolio, to some market variable A single trade may have Exposure to multiple market variables, and we measure the Exposure to each variable separately. In general there is an Exposure to each independent market variable that determines the value of the trade Detail Consider a simple Physical fixed price Forward delivering in a year's time There is an Exposure to the commodity underlier, let's say a Coal value The Exposure is the shift in value of the trade with each unit shift in the price (or value) of the underlier So a trade to buy 100 tonnes of coal might shift by $1 per tonne, for each shift of $1 per tonne in the price of coal, the 100 tonnes Exposure is 100 100 whats? Let's look at the units. We want the shift in price = 100 tonnes * $1 per tonne = $100, per unit shift in the price of coal = $100 / $1 / tonne = 100 tonnes So the Exposure has units of the underlier! If you've looked at the definition of Delta you will have seen that Delta is properly the change in value per unit of the trade per change in value per unit of the underlier So we get the important formula Exposure = Position * Delta A trade may have multiple deltas and multiple Exposures - our simple Forward deal may not be as simple as we think: - There is a Delta and Exposure to the value of coal
- If we want to know the current value of the trade then there is a Delta and Exposure to the interest rate
- If we are a European trading organization and we want to know the value of our trade in Euros then there is a Delta and an Exposure to the FX rate between Dollars and Euros - the FX Exposure
Exposures are additive - they can be summed across a set of trades or portfolios Deltas are not additive - because they are dimensionless ratios | ||

## Floating | ||
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A financial side or leg of a trade that is not fixed in advance, but is dependent on the value of some observable (usually an index) at a pre-agreed time related to the delivery date Detail Most trades involve at least two legs or sides, in a straightforward physical Forward contract one side is the physical delivery of the commodity, the other is the cash payment in settlement of the commodity delivered In an indexed forward, or floating forward, the cash side is not fixed in advance, but related to an index (usually published daily), and generally fixed in daily or monthly either at the daily price or the average of the daily-published monthly price | ||

## Gamma | ||
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Gamma is one of the market risk Greeks It measures the sensitivity of the Delta to an underlier or market value It is of use when the value of the Delta itself varies with the value of the underlier - the Delta being the ratio of the value of the trade or portfolio to the value of an underlier or market value Detail A Physical Forward has a delta of approximately one with respect to the physical underlier, that is the value of a trade increases by 1% for every 1% increase in the underlier By contrast an Option may have a delta of anywhere between -1 and +1, and the delta is not constant At an underlier price of $20/tonne an Option might have a delta of 0.1, but at $40/tonne the delta might be 0.5 Trades with deltas that are constant are called linear (if we were to plot a graph of value against underlier it would be a straight line, the slope is the delta) Trades with deltas that change with the value of an underlier are called non-linear (if we were to plot a graph of value against underlier it would be not be straight - the gamma is the measure of curvature of the plot at a particular point on the graph) As an analogy think of delta as speed, it is the ratio of distance to time. Gamma is acceleration, just knowing the speed of an object doesn't tell us whether it is braking hard, accelerating, or at uniform speed - for that we need the acceleration Because gamma is the change in delta per unit change of price per unit volume of commodity and delta is dimensionless then Gamma has units of 1 / (Price/Volume) = Volume/Price, e.g. Therms/$ Some ETRMs use the term Gamma for the change in Exposure per unit change of price per unit volume of commodity and get Volume / (Price/Volume) = Volume | ||

## Greek | ||
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The Greeks are a set of Market Risk measures, using Greek (or Greek-like) letters to measure sensitivities of a trade or portfolio to the set of factors that affect the value of the trade or portfolio Detail For more detail see the individual glossary entries for: If you remember your Greek from school you'll already have spotted that Vega is not a Greek letter at all, just a word beginning with "V" that sounds faintly like a Greek letter | ||

## Hedge | ||
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To hedge is to offset, mitigate or reduce a risk or risks of an organization or individual by entering into contracts or trades A hedge is a trade or contract intended at least partly to reduce risk In Energy Trading the risk is usually market risk associated with other trades or contracts, or the operation of assets Detail Let's consider a very simple example Our organization buys oil for delivery next year, because it believes the price next year will be less than the strike price (the price we will pay for it). We're taking a risk we understand. But the strike price is in US Dollars (USD) so shortly after the delivery takes place we will have to pay for the delivery in USD (or the equivalent in another currency at the delivery time) We operate in GBP, but we don't know what the GBP price will be until delivery - so there is a risk the USD/GBP FX rate will move against us before delivery We call this risk FX exposure to US dollars We're not interested in currency speculation, so we buy the required USD now at the forward FX rate Now we have no risk associated with FX exposure We have hedged our FX exposure Hedging is usually carried out with Derivatives. In our example above we could have bought the dollars immediately, but then we would be exposed to the USD interest rates, so it's more likely we would hedge with a Forward contract or a Futures contract Hedging is frequently carried out with financially settled instruments: the profit or loss we make on the hedge offsets any additional cost of the physical trade See also Hedge Accounting and Delta Hedging which are related Another useful way to think of a hedge is a means of realizing a profit-making strategy (profit-making strategies invariably being associated with risk!). If we think we will make a profit bidding on capacity through a pipeline, then the hedges would be the deals to buy at the cheaper location and sell at the more expensive location By this extension we can also say that hedging a position is a way of saying flattening the position (for example of a book) by trading the position to somewhere else (for example another book, or externally) | ||