Dark Energy Consulting
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Detailed Glossary
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RISK |
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Index | ||
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An Index is a set of prices that are published for a commodity or product, usually derived from trading data, using an open and independent method Detail An index consists of a set of time periods, with an associated price (or set of prices) for a particular commodity or product for each of the time periods: The time periods are sometimes called grid points (or gridpoints) A typical index has daily granularity forward from the date it is published for a number of days, then monthly for some months, then quarterly, seasonal and annual For each time period there may be a bid price, an offer price, and an average (mean) price Indexes are usually published at the end of each trading day, and represent some sort of average of the prices that Forward and Futures contracts actually traded at on that day (or for a pre-defined period of the day) Various organizations publish indexes for different commodities and products: Exchanges publish indexes for the various products they offer Independent analysts publish indexes for commodities in markets they specialize Trading organizations use indexes to: Derive forward (valuation) curves Fix in floating prices of floating price trades Agree forward valuation of trade portfolios with counterparties for netting agreements There is some similarity between indexes and curves since they are both sets of time-series data. The main differences are: Indexes are published by independent organizations, and are available to any organization that wishes to subscribe to them Indexes only relate to prices of commodities and products Curves are usually created by, and proprietary to, the trading organizations that create them Curves consist of any time-series data, including valuation, volatility, interest rates etc.
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Linear trade | ||
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A trade with no optionality Detail Why? The linearity refers to the delta - that is the variation of the value of the trade with the main underlier Trades with no optionality have a value that is directly proportional to the value of the underlier - if we plot the value against the value of the underlier it will be a straight line - hence linear trade Trades with optionality do not have a linear relationship between value and underlier. As the value of the underlier becomes less and less favourable the value of the trade becomes nearer and nearer to zero Unsurprisingly these trades are known as non-linear | ||
Mark to Market | ||
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A way of valuing the unrealized P&L of a simple linear Forward, Futures contract or Swap Detail Most businesses that own assets or hold inventory routinely value those assets and inventory, the change in value between two points in time is the profit or loss Some assets, like computers, simply depreciate, and a simple depreciation percentage is used each year Other assets, like buildings, vary in value with the market conditions, and are generally valued using a mark to market principle (that is we simply look and see what the building is worth at the end of the accounting period) It's important to realize that each trade is an asset (or a liability) - it's a firm contract and must be valued like any other asset The current value of a single trade is the difference between the price paid, and the value of the delivered commodity when it is delivered (which may be a cargo, a day of gas delivery, or a half hour of power delivery) We can find the value of the commodity once it has delivered by looking up the spot trading price on the day of delivery But to value the deal before delivery we must mark the value of the delivered commodity to the market; that is we set the value of the commodity to the price that is currently being paid for the delivery period For example: We have bought 10,000 therms of gas for delivery in March next year at 25p per therm Each day we can look at the average traded price for that month, and mark the value of the 10,000 therms to that price After two days we note that March is trading at 27p a therm, so we mark the physical value to the market price of 27p, and subtract the price we will pay, 25p. The unrealized P&L is therefore £200 ((27p - 25p) * 10,000). Each day we will need to repeat this calculation until the delivery is complete | ||
P&L | ||
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Profit and Loss (P&L) is a finance and risk reporting term to describe the profitability of an individual trade, a book, a desk, or a company. Whilst the P&L of a company includes all activity, and costs (offices, staff etc.) the trading P&L is a measure of the profitability of a single, or a set of, trade(s) Detail P&L is a change in the value of something, or a set of things between two points in time You will often hear people refer to the P&L of the trade in terms of its value - the value at any point in time is effectively the difference between the value at that point in time, and the value before the trade was executed. We usually refer to this as the Lifetime to Date P&L or LTD P&L Often we are interested in the change in value, the P&L, from the start of the year, from the start of the month, or from the last valuation. These are respectively known as:
As an example, let's say we bought some shares in a company for £60, and a year later we sold them for £100, then it seems obvious that we made £40 profit, assuming there were no cost of buying the shares, or selling them, nor indeed any other costs directly associated with the buying or selling
Before continuing we will align our example with a more normal energy trading example.
In general traders don't buy a commodity, and then sell it later because of the difficulty and cost of storing energy commodities - see Storage
In general traders enter into a Forward contract, that is to buy the shares at fixed time in the future, at a fixed price
The other advantage of Forward contracts is that the trader can enter a Forward contract to sell, as well as buy, at some time in the future. This is known as taking a short - i.e. negative - position
In March 2018 we will give £60 to the seller of the shares. This is called the financial side or leg of the trade. It has a known cash value: £60
We call this the physical side or leg (it's physical because it's not cash, even though the share certificates are electronic, we still call this physical)
In general the first method is preferred because it is simpler, we may have to use the second method when we are not sure the position is entirely closed out, or we know some is, and some isn't.
if the first method sounds odd, think about buying and selling a house, once you've bought a house you're very interested in how much you paid for it, and how much it's currently worth. Once you sell it however, you're only really interested in the price you paid and the price you sold it. You have little real interest in the current price
P&L that may result in a cash flow in the future is often discounted back to present day value
We may refer to undiscounted, and discounted P&L
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Position | ||
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All physically settled derivatives imply either an obligation to deliver, or take delivery of, a commodity at a location at some time in the future The obligation to deliver a commodity is called a short position of that commodity at that location and time in the future The obligation to take delivery of a commodity is called a long position of that commodity at that location and time in the future Detail Traders sum the position of a set of trades to know their net position across that group of trades - usually called a portfolio, a book or a strategy. This is known as the traded, or trader, position Traders take a long position if they believe the value of the commodity at the time of delivery will be greater than the contract, or strike, price Traders take a short position if they believe the value of the commodity at the time of delivery will be less than the contract, or strike, price. Taking a short position is sometimes known as shorting Each time a trade is executed the trader's net position changes. Most traders update their net position as each trade is executed | ||
Realization | ||
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The p&l of trades (and cash flows) is described as:
Detail Most trades involve delivery at some point in the future Because the value of the commodity to be delivered is not known before the delivery, the value needs to be estimated or calculated from market data. For forwards and futures and other linear trade types the value may be estimated by a simple mark to market calculation For options and other non-linear trades the value may be calculated using the Black 76 method (derived from the earlier Black-Scholes method) We say the trade's value (its p&l) is unrealized because it is not yet known for certain, and is therefore a cause of market risk Once delivery has taken place, we know (or don't care about) the delivered value, the value of he trade is known and no longer varies. In effect the p&l is locked in, there is no more market risk associated with this trade and the p&l is said to be realized The p&l of a trade (or cash flow) moves from unrealized to realized when one or more of the following conditions has been met
Realization is the set of business rules that defines when p&l moves from unrealized to realized based on:
Realization is subjective: different organizations may have different business rules to determine realization | ||
Theta | ||
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The value of options varies with time, in general the uncertainty in the price of the underlier reduces as the moment of exercise approaches. Theta is the measure of how much the value of a trade, or set of trades, varies with time Detail Theta is one of the Greeks that measure sensitivity of the value of a trade or portfolio to the passage of time Like most Greeks, except Delta, it is zero for linear trades (trades with no optionality)
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Underlier | ||
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Something physical or tangible that may be referenced by a contract or trade Detail Financial derivatives are completely cash-based and usually have no physical underliers Energy derivatives usually have at least one physical underlier, which may be a commodity, e.g. coal or a something related to a commodity e.g. storage The underlier acts as a bridge to the physical world - and usually as a set of reference prices for price-setting and valuation We need to emphasize that nearly all energy trades have at least one physical underlier - few of them actually involve the delivery of energy commodities
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SETTLEMENT |
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APAR | ||
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Accounts Payable/Accounts Receivable Anything relating to these two departments, that is:
Often used to refer to invoices and invoiced cash flows Detail In general the Master Agreement of a trade determines the agreed invoicing cycle and dates A typical invoicing cycle would be to invoice a month's worth of delivery on the 5th day of the following month Our organization must raise invoices, and may raise shadow invoices or purchase orders to match against invoices received from our counterparties Once sent, an invoice cannot be deleted or just ignored, but it can be reversed by issuing a credit note. A credit note reverses part of, or a whole invoice Equally a debit note may be raised to reverse part of, or all of, a shadow invoice or purchase order. This should match a credit note that our counterparty will send to us The set of invoices, shadow invoices and purchase orders, credit notes and debit notes, and the cash flows held in them may be collectively referred to as APAR | ||
Clearing | ||
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A form of settlement where responsibility for payment is passed to a third party: a Clearing House or Clearing Broker The Clearing House accepts responsibility for settling the deal. Credit risk for the seller in the trade is reduced to almost zero The Clearing House minimizes its Credit Risk by daily margining Detail An organization may trade on an Exchange either by becoming a member of the Exchange, or trading through an Exchange Broker. The clearing principles are similar in either case In general a trading organization engages a Clearing Broker to act on its behalf The trading organization is required to open a margin account with the Clearing Broker, which in turn maintains a margin account with the Exchange's Clearing Bank As the organization enters into a trading position the Exchange marks the trades to market on a daily basis, and transfers cash into or out of margin accounts based on the change of the value of the trading position since the previous day. The Clearing Broker mirrors this operation to its clients' margin accounts Every trading organization is required to maintain an amount of cash in the margin account to cover a substantial short term loss in the value of its position. If the trading organization does not maintain this margin then the Exchange closes out the position immediately, using the margin account cash to cover any losses as a result of the close out Payments into the margin account as a result of new trades that cause an increased open position are called Initial Margin payments Payments into the margin account as a result of the value of trades falling are called Variation Margin payments | ||