Handbook of Multi-Commodity Markets and ProductsOver recent decades, the marketplace has seen an increasing integration, not only among different types of commodity markets such as energy, agricultural, and metals, but also with financial markets. This trend raises important questions about how to identify and analyse opportunities in and manage risks of commodity products.

The Handbook of Multi-Commodity Markets and Products offers traders, commodity brokers, and other professionals a practical and comprehensive manual that covers market structure and functioning, as well as the practice of trading across a wide range of commodity markets and products. Written in non-technical language, this important resource includes the information needed to begin to master the complexities of and to operate successfully in today’s challenging and fluctuating commodity marketplace.

Designed as a practical practitioner-orientated resource, the book includes a detailed overview of key markets – oil, coal, electricity, emissions, weather, industrial metals, freight, agricultural and foreign exchange – and contains a set of tools for analysing, pricing and managing risk for the individual markets. Market features and the main functioning rules of the markets in question are pres- ented, along with the structure of basic financial products and standardised deals. A range of vital topics such as stochastic and econometric modelling, market structure analysis, contract engineering, as well as risk assessment and management are presented and discussed in detail with illustrative examples to commodity markets.

The authors showcase how to structure and manage both simple and more complex multi-commodity deals. Addressing the issues of profit-making and risk management, the book reveals how to exploit pay-off profiles and trading strategies on a diversified set of commodity prices. In addition, the book explores how to price energy products and other commodities belonging to markets segmented across specific structural features.

The Handbook of Multi-Commodity Markets and Products includes a wealth of proven methods and useful models that can be selected and developed in order to make appropriate estimations of the future evolution of prices and appropriate valuations of products. The authors additionally explore market risk issues and what measures of risk should be adopted for the purpose of accurately assessing exposure from multi-commodity portfolios.

This vital resource offers the models, tools, strategies and general information commodity brokers and other professionals need to succeed in today’s highly competitive marketplace.

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Over recent decades, the marketplace has seen an increasing integration, not only among different types of commodity markets such as energy, agricultural, and metals, but also with financial markets. This trend raises important questions about how to identify and analyse opportunities in and manage risks of commodity products.

The Handbook of Multi-Commodity Markets and Products offers traders, commodity brokers, and other professionals a practical and comprehensive manual that covers market structure and functioning, as well as the practice of trading across a wide range of commodity markets and products. Written in non-technical language, this important resource includes the information needed to begin to master the complexities of and to operate successfully in today’s challenging and fluctuating commodity marketplace.

Designed as a practical practitioner-orientated resource, the book includes a detailed overview of key markets – oil, coal, electricity, emissions, weather, industrial metals, freight, agricultural and foreign exchange – and contains a set of tools for analysing, pricing and managing risk for the individual markets. Market features and the main functioning rules of the markets in question are presented, along with the structure of basic financial products and standardised deals. A range of vital topics such as stochastic and econometric modelling, market structure analysis, contract engineering, as well as risk assessment and management are presented and discussed in detail with illustrative examples to commodity markets.

The authors showcase how to structure and manage both simple and more complex multi-commodity deals. Addressing the issues of profit-making and risk management, the book reveals how to exploit pay-off profiles and trading strategies on a diversified set of commodity prices. In addition, the book explores how to price energy products and other commodities belonging to markets segmented across specific structural features.

The Handbook of Multi-Commodity Markets and Products includes a wealth of proven methods and useful models that can be selected and developed in order to make appropriate estimations of the future evolution of prices and appropriate valuations of products. The authors additionally explore market risk issues and what measures of risk should be adopted for the purpose of accurately assessing exposure from multi-commodity portfolios.

This vital resource offers the models, tools, strategies and general information commodity brokers and other professionals need to succeed in today’s highly competitive marketplace.

Preface xix Acknowledgements xxiii About the Editors xxv List of Contributors xxvii PART ONE Commodity Markets and Products CHAPTER 1 Oil Markets and Products 3 Cristiano Campi and Francesco Galdenzi 1.1 Introduction 3 1.2 Risk Management for Corporations: Hedging Using Derivative Instruments 4 1.2.1 Crude Oil and Oil Products Risk Management for Corporations 4 1.3 Oil Physical Market Hedging and Trading 41 Further Reading 66 CHAPTER 2 Coal Markets and Products 67 Lars Schernikau 2.1 Introduction 67 2.2 Source of Coal – Synopsis of the Resource Coal 72 2.3 Use of Coal – Power Generation and More 90 2.4 Overview of Worldwide Steam Coal Supply and Demand 102 2.5 The Global Steam Coal Trade Market and its Future 121 2.6 Concluding Words 129 Abbreviations and Definitions 130 Acknowledgements 132 References 132 CHAPTER 3 Natural Gas Markets and Products 135 Mark Cummins and Bernard Murphy 3.1 Physical Natural Gas Markets 135 3.2 Natural Gas Contracting and Pricing 154 3.3 Financial Natural Gas Markets 158 References 180 CHAPTER 4 Electricity Markets and Products 181 Stefano Fiorenzani, Bernard Murphy and Mark Cummins 4.1 Market Structure and Price Components 181 4.2 Renewables, Intra-Day Trading and Capacity Markets 205 4.3 Risk Measures for Power Portfolios 216 References 221 Further Reading 221 CHAPTER 5 Emissions Markets and Products 223 Marc Chesney, Luca Taschini and Jonathan Gheyssens 5.1 Introduction 223 5.2 Climate Change and the Economics of Externalities 224 5.3 The Kyoto Protocol 227 5.4 The EU ETS 232 5.5 Regional Markets: A Fragmented Landscape 239 5.6 A New Asset Class: CO2 Emission Permits 241 Abbreviations 252 References 252 CHAPTER 6 Weather Risk and Weather Derivatives 255 Alessandro Mauro 6.1 Introduction 255 6.2 Identification of Volumetric Risk 257 6.3 Atmospheric Temperature and Natural Gas Market 264 6.4 Modification of Weather Risk Exposure with Weather Derivatives 272 6.5 Conclusions 276 Nomenclature 277 References 277 CHAPTER 7 Industrial Metals Markets and Products 279 Alessandro Porru 7.1 General Overview 279 7.2 Forward Curves 305 7.3 Volatility 337 Acknowledgements 352 References 353 Further Reading 353 CHAPTER 8 Freight Markets and Products 355 Manolis G. Kavussanos, Ilias D. Visvikis and Dimitris N. Dimitrakopoulos 8.1 Introduction 355 8.2 Business Risks in Shipping 356 8.3 Freight Rate Derivatives 366 8.4 Pricing, Hedging and Freight Rate Risk Measurement 382 8.5 Other Derivatives for the Shipping Industry 393 8.6 Conclusion 396 Acknowledgements 396 References 397 CHAPTER 9 Agricultural and Soft Markets 399 Francis Declerk 9.1 Introduction: Stakes and Objectives 399 9.2 Agricultural Commodity Specificity and Futures Markets 400 9.3 Demand and Supply, Price Determinants and Dynamics 409 9.4 Hedging and Basis Management 466 9.5 The Financialization of Agricultural Markets and Hunger: Speculation and Regulation 480 9.6 Conclusion about Hedging and Futures Contracts 493 References 495 Further Reading 496 Glossary, Quotations and Policy on Websites 497 CHAPTER 10 Foreign Exchange Markets and Products 499 Antonio Castagna 10.1 The FX Market 499 10.2 Pricing Models for FX Options 509 10.3 The Volatility Surface 511 10.4 Barrier Options 512 10.5 Sources of FX Risk Exposure 513 10.6 Hedging FX Exposures Embedded in Energy and Commodity Contracts 517 10.7 Typical Hedging Structures for FX Risk Exposure 533 References 553 PART TWO Quantitative Topics CHAPTER 11 An Introduction to Stochastic Calculus with Matlab Examples 557 Laura Ballotta and Gianluca Fusai 11.1 Brownian Motion 558 11.2 The Stochastic Integral and Stochastic Differential Equations 566 11.3 Introducing Itˆo’s Formula 575 11.4 Important SDEs 581 11.5 Stochastic Processes with Jumps 618 References 633 Further Reading 633 CHAPTER 12 Estimating Commodity Term Structure Volatilities 635 Andrea Roncoroni, Rachid Id Brik and Mark Cummins 12.1 Introduction 635 12.2 Model Estimation Using the Kalman Filter 635 12.3 Principal Components Analysis 646 12.4 Conclusion 655 Appendix 655 References 657 CHAPTER 13 Nonparametric Estimation of Energy and Commodity Price Processes 659 Gianna Figà-Talamanca and Andrea Roncoroni 13.1 Introduction 659 13.2 Estimation Method 660 13.3 Empirical Results 663 References 672 CHAPTER 14 How to Build Electricity Forward Curves 673 Ruggero Caldana, Gianluca Fusai and Andrea Roncoroni 14.1 Introduction 673 14.2 Review of the Literature 674 14.3 Electricity Forward Contracts 675 14.4 Smoothing Forward Price Curves 677 14.5 An Illustrative Example: Daily Forward Curve 679 14.6 Conclusion 684 References 684 CHAPTER 15 GARCH Models for Commodity Markets 687 Eduardo Rossi and Filippo Spazzini 15.1 Introduction 687 15.2 The GARCH Model: General Definition 690 15.3 The IGARCH(p,q) Model 699 15.4 A Permanent and Transitory Component Model of Volatility 700 15.5 Asymmetric Models 702 15.6 Periodic GARCH 707 15.7 Nesting Models 708 15.8 Long-Memory GARCH Models 713 15.9 Estimation 720 15.10 Inference 722 15.11 Multivariate GARCH 725 15.12 Empirical Applications 727 15.13 Software 740 References 748 CHAPTER 16 Pricing Commodity Swaps with Counterparty Credit Risk: The Case of Credit Value Adjustment 755 Marina Marena, Gianluca Fusai and Chiara Quaglini 16.1 Introduction 755 16.2 Company Energy Policy 756 16.3 A Focus on Commodity Swap Contracts 758 16.4 Modelling the Dynamics of Oil Spot Prices and the Forward Curve 760 16.5 An Empirical Application 764 16.6 Measuring Counterparty Risk 777 16.7 Sensitivity Analysis 788 16.8 Accounting for Derivatives and Credit Value Adjustments 788 16.9 Conclusions 797 References 798 Further Reading 798 CHAPTER 17 Pricing Energy Spread Options 801 Fred Espen Benth and Hanna Zdanowicz 17.1 Spread Options in Energy Markets 801 17.2 Pricing of Spread Options with Zero Strike 805 17.3 Issues of hedging 813 17.4 Pricing of Spread Options with Nonzero Strike 815 Acknowledgement 824 References 825 CHAPTER 18 Asian Options: Payoffs and Pricing Models 827 Gianluca Fusai, Marina Marena and Giovanni Longo 18.1 Payoff Structures 832 18.2 Pricing Asian Options in the Lognormal Setting 833 18.3 A Comparison 856 18.4 The Flexible Square-Root Model 858 18.5 Conclusions 874 References 874 CHAPTER 19 Natural Gas Storage Modelling 877 Álvaro Cartea, James Cheeseman and Sebastian Jaimungal 19.1 Introduction 877 19.2 A Simple Model of Storage, Futures Prices, Spot Prices And Convenience Yield 878 19.3 Valuation of Gas Storage 880 References 899 CHAPTER 20 Commodity-Linked Arbitrage Strategies and Portfolio Management 901 Viviana Fanelli 20.1 Commodity-Linked Arbitrage Strategies 902 20.2 Portfolio Optimization with Commodities 921 Symbols 936 References 936 CHAPTER 21 Econometric Analysis of Energy and Commodity Markets: Multiple Hypothesis Testing Techniques 939 Mark Cummins 21.1 Introduction 939 21.2 Multiple Hypothesis Testing 940 21.3 Energy–Emissions Market Interactions 943 21.4 Emissions Market Interactions 953 21.5 Quantitative Spread Trading in Oil Markets 956 References 964 APPENDIX A Quick Review of Distributions Relevant in Finance with Matlab Examples 967 Laura Ballotta and Gianluca Fusai Index