the journal of energy markets

7/28/2019 The Journal of Energy Markets

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The Journal of Energy Markets (2746) Volume 2/Number 3, Fall 2009

Cointegration between gas

and power spot prices

Cyriel de Jong

Kyos Energy Consulting/Erasmus University Rotterdam,

Lange Herenstraat 38 zwart, 2011 LJ Haarlem, the Netherlands;

email: [email protected]

Stefan Schneider

EON Energy Trading, Holzstrasse 6, 40221 D usseldorf, Germany;

email:[email protected]

The concepts of correlation and cointegration deserve some extra explanation. In

financial and energy markets, time series are often assumed to be correlated in returns.

The Journal of Energy Markets Volume 2/Number 3, Fall 2009

2009 Incisive Media. Copying or distributing in print or electronic

forms without written permission of Incisive Media is prohibited.Cointegration between gas and power

spot prices 31

This is a useful concept and is especially applicable for analysis with a short-term

horizon, such as short-term risk and hedging calculations. However, even a strong

correlation of close to 1 does not ensure that prices of different time series stay

together over longer horizons. In energy markets, such economically dridriven longerterm fundamentals

do exist.

For circumstances where economic fundamentals eventually enforce a specific

relationship between two or more price series, the concept of cointegration becomes

very useful. Important work on this concept has been performed by Clive Granger

and Robert Engle. The two professors shared the 2003 Nobel Memorial Prize for their
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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In the electricity business, we talk A LOT about natural gas market. Where is the market going?

What affects the market? If our business is mostly about electricity, why do we talk so much about

natural gas? Simply put, the greatest driver of electricity prices is the price of natural gas. Lets take a

look at why this important correlation exists.

First, a significant amount of electricity that is generated in the U.S. comes from the burning

of natural gas historically its been about 20%. The rest comes from coal (about 50%),

nuclear (about 20%), hydro-electric (about 8%) and renewable (about 1%). If 50% of all

electricity generated in the U.S. comes from coal, why is the correlation between naturalgas more important? To answer that question, youll need to understand the order in which

electricity generators are dispatched and how prices for electricity are set.

Click hereto view a Gas Power chart. Continue reading to learn what it means.

Typically, generators are dispatched in a least-cost first model, meaning the generators

that can make electricity the cheapest are turned on first.

1. Large hydro-electric units (mainly in the Pacific northwest) and wind units are typically thefirst to start running, which makes sense because their fuel costs are basically zero (the costs to

install these units is quite high relative to fossil fuel plants, but once theyre in, the fuel costs

are almost nothing).

2. Nuclear units are also dispatched earlier because they are referred to as baseload units,

meaning they have limited flexibility to turn on and off. They are very good at generating a

large and even amount of electricity, but are not typically used to ramp up and down quickly to

meet the needs of incremental demand.

3. Coal is similar to nuclear in that they are very good at providing baseload power. Fuel for

nuclear and coal plants has historically been cheaper than natural gas.

4. Natural gas plants can be much more flexible in their ability to turn on and off and to ramp up

and down to meet the needs of demand. Historically, natural gas has been more expensive as a

fuel source than coal and nuclear. This has changed somewhat as the flood of cheap and

abundant shale gas has hit the market, but for the most part, natural gas plants are dispatched

last.
http://www.electricavenueblog.com/wp-content/uploads/2013/01/Lars_GasPowerChart1.pdfhttp://www.electricavenueblog.com/wp-content/uploads/2013/01/Lars_GasPowerChart1.pdfhttp://www.electricavenueblog.com/wp-content/uploads/2013/01/Lars_GasPowerChart1.pdf


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So, if natural gas plants are the most expensive to run, why is the correlation with electricity

the strongest? Drum roll pleaseIts because the price for all electricity is set by the plants

that are dispatched last. This is called the marginal price, and all generators are paid this

price (within given locational constraints).

Supply and Demand Supply and demand are what driveprices , so any overall increase in demand for energy will

cause both gas and coal to go up in price. Conversely, any overall increase in energy supplywill drive gas and coal prices down. In that sense the prices of the two energy sources arecorrelated.

Winter

During the winter months in temperate regions, people tend to need more heat from naturalgas and stay indoors using electricity more. The two prices will be correlated because of anincrease in demand for both.

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Shortages Divergence in the two prices can occur if there is a shortage in one and no increase in

demand for the other. In the mid-2000s, there was a natural gas shortage in the world thatcaused theprice to spike, but coal remained stable so there was no correlation.

The Effect of Renewable Energy Sources

As more renewable energy sources come onto the market they will likely drive demand fornatural gas and coal down, causing a correlation between the two. The price of electricitymight also drop if it is based on renewable energy sources.

It Is Multifactorial

The fact is that sometimes there is a correlation between the prices of natural gas andelectricity, and sometimes there is not. There are many factors that determine the

correlation and predicting them is a very complex task.

Read more:Correlation Between Natural Gas & Electric Prices |

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4/10

Och-Ziff Capital Management (NYSE:OZM), the publicly-traded fund of funds, is getting some attention today from its

13F disclosure to the SEC in May. The asset manager disclosed that it bought nearly $12B in equity options in the

first quarter of 2011. Some traders interpreted this as a straightforward bet on increasing volatility, but I had the

following comments in aBloomberg story this morning:

Och-Ziff might be following an options strategy known as a dispersion trade that has become increasingly popular

this year, said Jared Woodard, principal at Condor Options, a New York-based trading and research firm that focuses

on market-neutral strategies.

Dispersion trades are a way of betting on an end to the historically high market correlation that began during 2008,

when shares of companies in various industries all rose and fell together, frustrating money managers who earned

their keep by researching and picking individual companies.

In a dispersion trade, managers sell put and call options on an index such as the S&P 100 during market declines,

when demand is heavy among investors who want to protect themselves from losses. They use the rich premiumsreceived for the index options to buy put and call options on some or all of the stocks comprising the index.

The option purchases were pretty evenly split, with $4.65B of calls and puts worth $7.14B purchased. The missing

piece that would really cement this dispersion trade thesis is if we knew that OZM had also sold some index options

in size. They havent disclosed any such position in the index.

Even so, I would be surprised if this wasnt some sort of bet on dispersion. Och-Ziff reportedly bought options on 93

of the stocks in the S&P 100, and that doesnt sound like tactical stock -picking to me. Implied correlation has

remained high since 2008, with readings in the 60-65 range for the CBOEs implied correlation indexes (pictured)

constituting the new normal. A return to the previous era would see those indexes back in the 30 -40 range. Im not

actually a fan of betting against high correlation here, even several years after the financial crisis. Intuitively, an

environment in which individual index components move more independently is an environment in which the details

of those individual companies are the primary drivers of stock prices, and broad macroeconomic factors are less

important. As far as I can tell, were still living in a risk-on/risk-off world.

You know how, when guests and anchors on financial television networks run out of things to say, they sometimes

resort to, Well, its a stock-pickers market? Besides being perennially vapid, as far as I can tell that claim is still

mostly false.

Many dealers were badly hurt by short single-stock variance positions at the end of 2008.

Despite this, a number of banks have reopened dispersion desks this year to tap into

renewed investor interest in the trade. Have they learned any lessons? By Matt Cameron

Dispersion has proved to be disastrous for equity derivatives dealers in the past. Before the crisis,

banks loaded up with short single-stock variance exposures as part of dispersion packages put on

with hedge funds positions that led to massive losses when volatility surged and liquidity dried up

in the listed options market after the collapse of Lehman Brothers in September 2008. Response

from the market was swift: some shut down dispersion desks altogether, while others stopped

quoting on single-stock variance and put greater focus on volatility swaps.
http://www.google.com/finance?q=NYSE:OZMhttp://www.google.com/finance?q=NYSE:OZMhttp://www.google.com/finance?q=NYSE:OZMhttp://www.bloomberg.com/news/2011-06-16/och-ziff-may-profit-from-market-turbulence-with-12-billion-options-bet.htmlhttp://www.bloomberg.com/news/2011-06-16/och-ziff-may-profit-from-market-turbulence-with-12-billion-options-bet.htmlhttp://www.bloomberg.com/news/2011-06-16/och-ziff-may-profit-from-market-turbulence-with-12-billion-options-bet.htmlhttp://www.bloomberg.com/news/2011-06-16/och-ziff-may-profit-from-market-turbulence-with-12-billion-options-bet.htmlhttp://www.google.com/finance?q=NYSE:OZM


5/10

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The past six months have shown that memories are short. Several banks have reopened dispersiondesks this year, keen to tap into renewed interest from investors. But dealers say they have learned

some lessons from 2008, with strict limits on short single-stock variance exposures now in place.

Others say they are pushing options strategies rather than variance to allow investors to profit from

dispersion.

The recent investor interest is the result of a huge discrepancy between implied and realised

correlation since July. The escalating Greek debt crisis and fears of contagion throughout the

eurozone caused investors to dump risky assets en masse in the second quarter, contributing to a

rapid jump in volatility and implied and realised correlation. Realised correlation quickly dropped

back, but implied correlation has remained at elevated levels creating an eye-catching differential

for investors to exploit.

The decision to reopen our dispersion trading desk after shutting it down last year has largely been

driven by the macro environment. The disparity between implied and realised correlation has really

attracted a lot of attention, with correlation on the Dow Jones Eurostoxx 50 index realising on

average 20 points below implieds. Investors have looked to profit from the carry, and there has been

a lot of opportunity in this space, says Cyrille Walter, head of European equity trading at Morgan

Stanley in London.

The difference between implied and realised correlation remained high until the beginning of last

month. On November 10, 180-day implied correlation on the Dow Jones Eurostoxx 50 was at71.12%, while 10-day and 30-day realised correlation was at 45.15% and 44.63%, respectively,

according to Morgan Stanley. However, the differential began to narrow as concerns about Ireland

and Portugal began to escalate later in the month, with 180-day implied correlation on the Eurostoxx

reaching 73.54% on November 23, versus 74.16% and 55.17% for 10-day and 30-day realised

correlation, respectively. This recent move could potentially hurt the mark-to-market value of

dispersion packages transacted in the previous months.

Prior to 2008, variance swaps were by far the most popular way of putting on dispersion trades.

These products give a payout equal to the difference between realised variance (the square of

volatility) and a pre-agreed strike, times the vega notional. The payout of a variance swap is convexin volatility, meaning investors going long a variance swap can benefit from increased gains

compared with direct exposure to volatility, while exposing sellers to greater losses if volatility surges.

To put on a dispersion trade, a hedge fund would sell a variance swap on an index and buy variance

swaps on the constituent stocks, giving it a short correlation position. The investor would profit if the

individual stocks performed in an idiosyncratic way, with variance on individual stocks rising more

than the index. Conversely, dealers are long correlation a situation thought to be ideal from their
http://www.risk.net/asia-risk/feature/2251529/viva-las-vega-japan-banks-take-advantage-of-volatility-playhttp://www.risk.net/asia-risk/feature/2251529/viva-las-vega-japan-banks-take-advantage-of-volatility-playhttp://www.risk.net/risk-magazine/feature/2202234/traders-close-ranks-against-fva-criticshttp://www.risk.net/risk-magazine/feature/2202234/traders-close-ranks-against-fva-criticshttp://www.risk.net/risk-magazine/feature/2195461/risk-25-no-more-heroes-in-quantitative-financehttp://www.risk.net/risk-magazine/feature/2195461/risk-25-no-more-heroes-in-quantitative-financehttp://www.risk.net/risk-magazine/research/2180064/risk-institutional-investor-rankings-2012http://www.risk.net/risk-magazine/research/2180064/risk-institutional-investor-rankings-2012http://www.risk.net/risk-magazine/research/2180064/risk-institutional-investor-rankings-2012http://www.risk.net/risk-magazine/feature/2195461/risk-25-no-more-heroes-in-quantitative-financehttp://www.risk.net/risk-magazine/feature/2202234/traders-close-ranks-against-fva-criticshttp://www.risk.net/asia-risk/feature/2251529/viva-las-vega-japan-banks-take-advantage-of-volatility-play


6/10

perspective pre-2008, as it allowed them to offset structural short correlation positions built up

through their structured products businesses.

These exposures specifically, the short single-stock variance leg hit dealers hard in the fourth

quarter of 2008. In theory, short single-stock variance positions can be hedged with a static portfolio

of put and call options struck along a continuum between zero and infinity and weighted inverselyproportional to the squared strike. In practice, dealers tended to focus on a limited number of strikes

relatively close to the spot level. After Lehmans collapse, however, liquidity in listed options dried up

dramatically, making it extremely costly and virtually impossible in some cases to rebalance

hedges. The end result was billions in losses and the closing of dispersion desks at some institutions.

This time around, dealers claim to have limited the amount of crossed-vega they are willing to take

through dispersion. Crossed-vega represents the amount of vega traded on both single stocks and

indexes, with $10 million of crossed-vega equal to $10 million of vega on stocks and $10 million on

the index. Pre-crisis, some banks are believed to have warehoused crossed-vega exposures of up to

$100 million those that spoke to Risknow say they have between $5 million and $20 million ofcrossed-vega.

The limits most banks are allocating to market activities are way below what they were prior to

Lehman. If some banks held exposures of up to $20 million of crossed-vega, then it will definitely not

be more than $5 million now. The sizes of trades have also been scythed. Two years ago, you would

get trades as big as $2.5 million of vega now $500,000 is a large trade. We are certainly not in

days where you can trade $2 million a clip, says Dan Fields, global head of trading at Socit

Gnrale Corporate and Investment Banking (SG CIB) in Paris.

Others agree. Walter at Morgan Stanley says the bank has imposed strict limits on crossed-vega

exposure since reopening the dispersion desk. That applies to dispersion trades conducted through

variance swaps, volatility swaps and also straddles, which involve the sale of a put and call option on

an index with the same strike and expiry, and the purchase of puts and calls on the constituent

stocks. This is a blanket limit imposed across the different types of instruments, from straddles to

variance swaps, he says.

In fact, some dealers say they are more comfortable with straddle dispersion in recognition of the

risks posed by holding short single-stock variance swap positions in a market crash. The risks can

differ region by region, with Asia in particular seen as being susceptible to a sudden drying up of

liquidity in options.

Variance dispersion can be difficult to risk-manage because of the tail risks inherent in selling

single-stock variance swaps. The losses that many banks sustained during the crisis really altered

risk appetite for the product. We still trade variance dispersion, but with strict limits on the single-

stock exposures we are willing to take, which varies by region and underlying liquidity. We prefer to

offer volatility swap and straddle dispersion, but we can provide prices on all three, says Roger

Naylor, head of equity derivatives at Deutsche Bank in London.


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Most dealers claim to offer a variety of instruments for trading dispersion, with straddles playing a

more prominent part of the business. Stphane Mattatia, global head of flow equity derivatives

financial engineering at SG CIB in Paris, says straddles have certain advantages over variance

swaps specifically, higher implied correlation.

When you trade straddles, you can trade with a higher level of implied correlation than a varianceswap. Thats because when you hedge a variance swap, you have to buy a strip of downside puts,

which are less liquid and have a replication cost. This adds to the liquidity cost of the swap and

affects the level of correlation priced in, explains Mattatia.

There are, however, some disadvantages to using vanilla options to trade dispersion. The major

drawback is the need to delta hedge the position something not all investors have the

infrastructure to do. As a result, some dealers offer to delta hedge the options on behalf of clients, in

return for a fee of around 510 basis points.

This service does not appeal to all investors. Trading dispersion using straddles entails a little morework because you have to delta hedge the options. As a result, its essential you have the trading

infrastructure to do it. We seriously investigated some of the offers by dealers to do the hedging for

us, but we didnt take it further after analysing the cost savings dealers were offering relative to the

delta-hedging work. We realised the economics werent right, and our decision was primarily cost-

based. Dealers seemed to view this as a small money-making operation rather than a service, says

the head of equity strategies at a US hedge fund in New York.

Another possible disadvantage is the gamma on straddle dispersion, says SG CIBs Mattatia.

(Gamma is the rate of change in the delta of an option given a change in the price of the underlying.)

Most of the gamma on straddles is contained around the strike of the options. In a range-bound

market, a straddle is a good trade because you will keep most of your gamma. But if the market

moves far from the strike, you end up losing most of your gamma. For example, if you are long a

straddle on single stocks with a strike of 100 and short the index, you will make money if the stocks

disperse around the strike and you are able to delta hedge. However, if the market experiences a

massive rally and the straddles are all in-the-money and you have a delta of 100%, you have nothing

more to hedge. If the stocks disperse around 120%, you wont capture the dispersion. Conversely,

whatever the level of dispersion, you will capture it with a variance swap, he says.

Variance swaps may give a pure exposure to volatility without the need to delta hedge, but a number

of disputes in 2008 have highlighted other risks with the product, beyond the difficulty of hedging

short single-stock variance exposures in stressed markets. In particular, there have beendisagreements over market disruption events, a clause written into single-stock variance contracts.

An event is deemed to have taken place if the dealer is unable to execute a hedge at the close of

trading each day, either due to market or exchange disruption. The calculation agent decides if an

event has occurred, then notifies the counterparty and extends the period until the following close.


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However, the number of disruption days on variance swap contracts, as determined by a calculation

agent, has led to several disagreements between hedge funds and dealers. This has been a huge

issue for us, says the head of equity strategies at the US hedge fund. Not only was there a lot of

ambiguity as to what was counted as a disruption day, if you read the traditional documentation it

gives a remarkable amount of discretion to the calculation agent (almost always the dealer), well

beyond what they should have.

The length of time taken by the calculation agent to inform the hedge fund that a market disruption

event has taken place has been a particular bone of contention. The dealer has an ob ligation to

notify the counterparty of a market disruption event as quickly as possible, but there is a carve-out

that says in no way does the timing have any impact on whether it is a disruptive day or not. This

means, in a perfect world, they are supposed to tell you as soon as they can. But they have the

ability, a year later, to still call the market disruption event. Weve had this happen and we have

pushed back it is just not within the spirit of the law. To come back a year later and claim on a

technical basis they couldnt hedge is absurd, he says.

Partly in response to these kinds of disagreements, the International Swaps and Derivatives

Association has amended variance swap documentation to clean up some of the ambiguities, says

Katherine Darras, general counsel for the Americas at Isda. The industry group also plans to set up

an equity determinations committee, which will establish whether a market disruption event has

occurred. The group is expected to comprise both sell- and buy-side participants.

However, some believe the mandate of the equity determinations committee does not extend far

enough. Isda is tackling the issue of market disruption events, and that is a good step forward for

the market, but other issues need to be looked at for example, the calculation of future implied

volatility to determine settlement prices on the delisting of a stock. This solely falls to the calculation

agent, and weve had situations where weve had a trade on with one dealer and a hedge with

another, and when a stock was delisted, the implied volatilities they both came up with were so far

apart it strained credibility and, big surprise, both were in favour of the dealer. These issues need

to be resolved, maybe by allowing hedge funds to become co-calculation agents on swaps, says

the equity strategist.

For their part, dealers are not keen on sharing calculation duties, arguing it will actually lead to an

increase in the number of disagreements. Hedge funds request this all the time, but it just opens the

door to more disputes. These are illiquid types of products and we have the expertise in valuing

them. Under the current process, the client always has the opportunity to get prices from the market

it is not a one-way relationship, says one equity derivatives exotics trader in London.

Other disputes have centred on the issue of caps a common feature in single-stock variance

swaps and some index variance swaps, designed to limit the downside of one party. For instance,

single-stock variance swaps typically trade with a cap of 2.5 times, meaning if a hedge fund went

long a swap with a strike of 20 points, the dealer would only be on the hook up to 50 points, and


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would be protected against a further rise in volatility. Some hedge funds claim it has not been clear

at inception whether a cap was included.

We had one instance where we ended up confirming a long index variance swap trade with a dealer

with a generic term sheet that had no cap. But the confirmation from the bank had a cap.

Unfortunately, the trade had already been booked. However, it was an index trade where we hadbought volatility at 30 points and it realised at 85, so the supposed cap at 75 wasnt breached in a

big way and we werent talking about massive cash amounts here. The issue was resolved because

there are market norms some indexes are generally capped while others are not. The market

standard went in our favour, claims the hedge fund manager.

Curbing dispersion exposureAuthor:Matt Cameron

Source:Risk magazine| 01 Dec 2010

Categories:Equity Derivatives

The Role of ABS, CDS and CDOs in the Credit

Crisis and the Economy

Robert A. Jarrow y

September 20, 2011

Abstract

The credit derivatives - ABS, CDS, and CDOs - played a signicant

role in the nancial crisis aecting both the nancial and real economy.

This paper explains their economic roles, using the credit crisis as an

illustration. It is argued that ABS are benecial providing previously

unavailable investment opportunities to market participants which facilitates the access to debt capital spurring real

economic growth. If properly
http://www.risk.net/author/339/matt-cameronhttp://www.risk.net/author/339/matt-cameronhttp://www.risk.net/author/339/matt-cameronhttp://www.risk.net/risk-magazinehttp://www.risk.net/risk-magazinehttp://www.risk.net/risk-magazinehttp://www.risk.net/category/derivatives/equity-derivativeshttp://www.risk.net/category/derivatives/equity-derivativeshttp://www.risk.net/category/derivatives/equity-derivativeshttp://www.risk.net/category/derivatives/equity-derivativeshttp://www.risk.net/risk-magazinehttp://www.risk.net/author/339/matt-cameron


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collateralized, CDS are also benecial because they enable market participants to more easily short sell debt,

thereby increasing the informational

e ciency of credit markets. And, similar to mutual funds, CDOs provide

investors with desired investments (cash ow streams) at reduced transaction costs. Prior to the credit crisis, CDOs

were used to exploit market

mispricings caused by the credit agenciesmisratings of structured debt.

These mispricings were persistent due to both the complexity of the CDOs

and the dysfunctional institutional and regulatory structures present in

the economy. The regulatory reforms needed in this regard are herein

discussed

the journal of energy markets

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