Curves - FINC 782 Energy Markets Portfolio Analysis AB...

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1 Curves, Curves, Curves FINC 782: Energy Markets Portfolio Analysis AB Freeman School of Business, Tulane University, New Orleans, Fall 2007 Leslie McNew Email at [email protected] 865-5036
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2 What is a Forward Curve ? A forward curve is defined as one that allows market participants to lock in the indicated prices in advance at reasonable levels of liquidity. WE CAN ALSO CALL THIS THE RISK CURVE
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3 Different Types of Curves: yield Govt Bond Curve . 5 00 . 5 20 . 5 40 . 5 60 . 5 80 . 6 00 . 6 20 . 6 40 . 6 60 . 6 80 MO NTHS 3 MONTHS 6 YEAR 1 Y EA R 2 Y EA R 5 YE A R 10 YE AR 30 This forward curve represents interest rates to time to maturity: the risk free rate of return
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4 Different Types of Curves: price This forward curve illustrates a NE basis market with seasonality: natural gas TRANSCO Z Basis Curves 6 0 . 0 1 . 0 2 . 0 3 . 0 4 . 0 5 . 0 6 . 0 7 . 0 8 . 0 9 1 Mar- 00 Apr-Oct 00 Nov-Mar 01 Apr-Oct 01 Nov-Mar 02 Apr-Oct 02 Nov-Mar 03 Name Mar- 00 Apr-Oct 00 Nov-Mar 01 Apr-Oct 01 Nov-Mar 02 Apr-Oct 02 Nov-Mar 03 TRANSCO Z 6 . 0 7 . 0 2852 . 0 9130 . 0 2550 . 0 7751 . 0 2475 . 0 7751
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5 There are Market Curves and Fundamental Curves . 1 Market Curve (Risk Management): market and quantitatively derived price curve used by Risk Management for marking to market. Risk free assessment of the market that is independent from commercial decision making. (PG&E expects the proprietary curves to diverge from this curve. Indeed it is that difference that must be exploited to conduct profitable trades and structured deals.) Further, the deviation from the market curve and the propriety curves can be simplified to the amount of risk that commercial is willing to take to earn an expected outcome. . 2 Proprietary Trading Curve (Traders): view of future forward prices, derived from a blend of market, quantitative, and fundamental economic equilibrium modeling. Used for trading, contract, and structured deal commercial decisions. . 3 Proprietary Investment Curve (US Gen): view of future spot prices derived from market data and fundamental economic equilibrium modeling. Used for commercial investment decisions such as acquisition, divestiture, and greenfield development.
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6 Building Curves WHAT ARE YOU USING IT FOR ? WHAT COMMODITY ARE YOU USING IT ON ?
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7 Classes of Forward Curve Models Arbitrage models Fundamental models ( ‘stack models’) Stochastic fundamental models (e.g. Bankers Trust) Models borrowed from finance Diffusion Jump-diffusion Models adapted from finance 1-, 2- and 3-factor models Focus on two-factor model Developed by Michael Brennan and Eduardo Schwartz for interest rates Adapted to commodities by Eduardo Schwartz and Rajna Gibson Estimated for commodities by Eduardo Schwartz and James Smith Misappropriated and mis-labelled the “Pilipovic Model”
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8 Spot + Cost of Carry = Forward Price Forward Curve Models: Arbitrage Interest storage transportation Arbitrage Free Relationship
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9 Forward Curve Models: Arbitrage Arbitrage upper bound for commodities Forward price cannot exceed spot plus net carrying costs
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