Description
Book SynopsisA hands-on guide to navigating the new fuel markets
Fuel Hedging and Risk Management: Strategies for Airlines, Shippers and Other Consumers provides a clear and practical understanding of commodity price dynamics, key fuel hedging techniques, and risk management strategies for the corporate fuel consumer. It covers the commodity markets and derivative instruments in a manner accessible to corporate treasurers, financial officers, risk managers, commodity traders, structurers, as well as quantitative professionals dealing in the energy markets.
The book includes a wide variety of key topics related to commodities and derivatives markets, financial risk analysis of commodity consumers, hedge program design and implementation, vanilla derivatives and exotic hedging products. The book is unique in providing intuitive guidance on understanding the dynamics of forward curves and volatility term structure for commodities, fuel derivatives valuation and counterpa
Table of Contents
Preface xiii
Acknowledgments xix
About the Authors xxi
CHAPTER 1 Energy Commodities and Price Formation 1
Energy as a Strategic Resource 1
Energy as a Tradable Commodity 3
Energy Commodities 5
Crude Oil 5
Oil Products 8
Natural Gas 11
Coal 11
Price Drivers in Energy Markets 12
Geopolitical Risks 12
The Geopolitical Chessboard – The Petrodollar System and Rising China 12
Long-Term Supply and Demand 15
Short-Term Supply and Demand: Supply Chain and Infrastructure 17
Financialization of Commodities 19
Market-Specific Price Drivers 19
Summary 20
CHAPTER 2 Major Energy Consumers and the Rationale for Fuel Hedging 23
Energy Market Participants 23
Risks Faced by Fuel Consumers – The Case of the Airline Industry 27
Airline Industry – Metrics and Operational Risks 27
Airline Industry – Financial Risks 30
Risks Faced by Other Major Fuel Consumers 35
Shipping Companies 35
Land Transportation 37
Oil Refining, Petrochemicals, and Power Generation 37
Industrial Users of Energy Commodities 38
The Case for Hedging 39
The Effect of Hedging on Airline Stock Price Volatility 39
Commodity Derivative Markets 41
A Brief History of Commodity Markets 42
Commodity Spot Markets and the Need for Standardization 43
Forward Contracts 44
Futures Contracts 45
Option Contracts 50
Summary 53
Appendix A 54
CHAPTER 3 Developing Fuel Hedging Strategies 55
The Rationale for Commodity Hedging 55
Developing a Fuel Hedging Program 57
Risk Identification and Assessment 57
Types of Risk 58
Risk Identification 59
Forecasting Prices and Conducting Simulations 59
Articulating the Firm’s Risk Appetite 60
Setting Objectives for Fuel Hedging and the Scope of Hedging 60
Identifying Risk Managers within the Organization 61
Determining the Scope of the Hedge Program 61
Implementation of Hedging 62
Selecting the Fuel Cost Management Method 62
Identifying the Underlying to Hedge with and Basis Risk 63
Quantity and Tenor of Hedging 66
Selection of Instruments for Hedging 67
Market Risk 68
Management of the Unwanted Risks of a Portfolio 68
Credit Risk 68
Liquidity Risk 69
Operational Risk 69
Legal and Reputational Risk 70
Monitoring and Calibration of the Hedging Program 70
Template for a Risk Management Policy 71
The Airline Industry – Trends in Fuel Risk Management 71
Magnitude of Fuel Price Risk 71
Underlyings and Hedging Instruments 73
Quantity and Tenor of Hedging 74
Recent Developments 75
Summary 75
CHAPTER 4 Shipping and Airlines – Basics of Fuel Hedging 77
Spot–Forward Relationships 77
Theories on the Shape of Forward Curves 78
Spot–Forward Relationships for Investment Assets 79
Spot–Forward Relationships for Commodities 80
Spot and Futures Volatility 81
Options 82
Call and Put Options 83
Put–Call Parity 84
Option-Based Hedging for a Shipping Company 85
Implied Volatility and the Black–Scholes Model 86
The Black–Scholes–Merton Model 88
Black’s Model for Pricing Options on Futures Contracts 89
The Greeks 89
Delta 90
Gamma 92
Theta 92
Vega 94
Rho 94
Higher-Order Greeks 95
Black’s Model Option Greeks 95
Asian Swaps and Options 96
Asian Swap-Based Hedging for a Shipping Company 97
Option Structures 97
Call Spreads and Put Spreads 97
Collars, Three-Ways, and Calendar Spread Options 99
Straddles, Strangles, and Butterflies 100
Capped Forwards 102
Capped Swap Usage for a Shipping Company 103
Derivatives Pricing 104
Stochastic Processes for Asset Prices – An Introduction 104
Brownian Motion and Wiener Processes 104
Itô’s Lemma 106
Option Pricing Using the Black–Scholes–Merton Formula 107
Asian Option Pricing 109
Summary 112
CHAPTER 5 Advanced Hedging and Forward Curve Dynamics 113
Swap and Vanilla Option-Based Structures 113
Zero-Cost Structures and the Usage of Options 114
Leveraged Swaps 114
Capped Swaps 116
Floored Swaps 117
The Volatility Surface 118
Multi-option Structures 119
Zero-Cost Collar 120
Three-Ways 120
Risk Reversals and their Hedging 121
Early-Expiry Options and Instantaneous Volatility Term Structures 122
The Samuelson Effect and the Storage Theory 122
Implied Volatility of Energy Futures Contracts 123
Early-Expiry Profile Construction 124
Commodity Swaptions and Extendible Swaps 127
Usage of Commodity Swaptions and the Reasons for their Popularity 127
Swaption vs. a Basket of Options 128
Understanding Commodity Futures Term Structures 133
The Normal Backwardation or Keynesian Theory 133
The Theory of Storage 134
Term-Structure Models 135
Schwartz’s One-Factor Model 135
Schwartz’s Two-Factor Model 136
Gabillon’s Model 137
Gabillon’s Stochastic Equation for Futures 138
Early-Expiry Profile Using Gabillon’s Model 139
Importance of Early-Expiry Profile for Exotic Products 139
Summary 140
CHAPTER 6 Exotic Hedging and Volatility Dynamics 141
Extendible Option Structures 142
Extendible Collar 142
Extendible Three-Ways 143
Cancellable – Extendible Parity 144
Pricing Extendible Option Structures 146
Volatility Models 150
Stochastic Volatility Models 150
Barrier Option-Based Structures 152
Knock-Out Options and Knock-In Options 152
Relationship between KI and KO Options 154
Knock-Out Swaps 154
Airbag Structure 154
KIKOs and Combinations of KI and KO Options 155
Accumulator Structures 156
European or Asian-Style Barrier Options 157
Barrier Payouts and Non-linearity – Digital Options and Replication 157
The Reflection Principle 160
Barrier Options Under the Black–Scholes Framework 161
Put–Call Symmetry 163
MTM Analysis of Barrier Options Under the Black–Scholes Framework 163
Pricing and Risk Management of Barriers with Real-World Constraints 165
Barrier Options on a Nearby Futures Contract 167
Local Volatility Models 168
Bermudan Extendible Structures 170
Valuation of Bermudan Extendibles 174
Longstaff–Schwartz Method and Exercise Boundaries 174
Extendible vs. Auto-callable Transactions 177
Bermudan Extendibles and the Forward Skew 177
The Inverse Leverage Effect in Commodities Markets 179
Target Redemption Structures 180
Target Redemptions and the 2008 Debacle 182
Defining Leverage 183
Target Redemption Pricing and Risk Management 184
The Mean-Reversion Trap 185
Target Redemption and Trading Risks 186
Sticky Strike and Sticky Delta 187
Sticky Strike Approach 187
Sticky Delta or Sticky Moneyness 188
Gamma/Theta Ratio 188
Summary 190
CHAPTER 7 Fuel Hedging and Counterparty Risk 191
The Importance of Valuation and Transaction Monitoring 191
Market Risk Management 192
Fuel Hedgers: Lottery Tickets and Spring Cleaning 193
Value at Risk 194
Liquidity Risk 195
Counterparty Risk 195
Credit Risk and Counterparty Risk 196
Expected Exposure 198
Potential Future Exposure 198
Measurement of Counterparty Risk for a Portfolio of Trades 198
Peak PFE 198
Common PFE Misconceptions and Pitfalls 200
Credit Exposure Optimization Techniques 202
Bilateral Netting Agreements 202
Credit Support Annexes 203
CSA Negotiations – Key Considerations 203
Funding Valuation Adjustment 206
Fuel Hedgers and FVA 207
The FVA Debate 209
The Price of Counterparty Credit Risk 209
Credit Derivatives and Credit Default Swaps 210
Credit Valuation Adjustment 212
Common CVA Mis-steps 213
Gap Options and Collateralization Agreements 213
Debt Valuation Adjustment 214
Fuel Hedgers and Debt Valuation Adjustments 214
The Case for Bilateral CVA 215
Wrong-Way Risk 216
Counterparty Credit Risk Hedging 216
Contingent CDS 216
Capped Exposure Derivatives 217
Summary 217
CHAPTER 8 Conducting Scenario Analysis 219
Scenario Analysis for Vanilla Products 220
Scenario Analysis for Path-Dependent Products 224
MTM-Based Scenario Analysis and Potential Future Exposures 229
Beyond Payoffs and MTMs – Collateralization and Funding Requirement Analysis 230
Hedge Effectiveness 231
Summary 233
CHAPTER 9 Financing and Risk Management: Bundled Solutions 235
Structured Aviation Finance Overview 235
Airline Financing via Debt and Aircraft Leases 238
Term Loans 239
Export Credit Agency Debt 240
Leases 240
Rationale for Combining Hedging and Financing 243
Reduction of Default Risk through Hedging 244
Oil-Linked Financing Structures 245
Flexible Oil-Insulated Lease 246
Cancellable Hedged Loans as Interest Cheapeners 250
Summary 252
CHAPTER 10 Applied Fuel Hedging – Case Studies 253
Case Study 1: YM Cargo Inc. 253
Business Risks 253
Operational Mitigants 254
Risk Appetite 255
Hedge Program Objectives and Scope 255
Implementation of Hedging 256
Portfolio Monitoring 260
Case Study 2: Worldwide Airlines 260
Evolution of WWA’s Hedging Strategy 262
Hedging Transactions Executed by WWA 264
Hedge Portfolio Analysis 267
Credit Lines and Collateralization Issues 269
Restructuring WWA’s Portfolio 271
Counterparty Risk and Funding Considerations for BMC 272
Summary 276
Bibliography 277
Index 281
