Practical Derivatives: KYOS consultants write chapter about Energy Derivatives

13 December 2010

Practical Derivatives: A Transactional Approach, 2nd Edition

practical-derivativesFeaturing updated chapters, this new second edition shows how derivatives are used in a variety of transactions, how the documentation works and why boards need to be aware of them. KYOS consultants Cyriel de Jong and Christopher Clancy wrote the chapter on energy derivatives.

With contributions from leading law firms including Sidley, Mayer Brown and Norton Rose, this accessible book takes a transactional approach and features coverage of new product innovations. These include equity and energy derivatives and the expansion of derivatives into new markets such as credit risk, weather risk and property. The book also features topical analysis on corporate governance and directors’ duties; ISDA documentation (including coverage of GMRAs); collateral; close-out netting and structured derivatives.

Energy derivatives and hedging strategies

The next few decades are expected to see another big rise in energy consumption. Depletion of existing energy sources and the need to comply with environmental regulations will simultaneously mean a shift towards alternative energy sources. This will bring huge shifts to the energy landscape and require massive investments. Without doubt, efficient derivatives markets will be a great help in making the right investments. They help to provide the right forward-looking price signals, assess future volatility levels and provide instruments now and in the future to manage energy exposure on both the production and consumption sides.
What makes trading and hedging in energy markets special? That is the central theme of this chapter. There is a wide variety of energy commodities and products, which reduces liquidity in individual products. Differences also exist in product specifications of the traded products, price behaviour and relevant hedging schemes. This chapter devotes considerable attention to power, the purest and most ready-to-use form of energy. The difficulty of storing and transporting power makes it an ideal candidate to demonstrate various properties of energy derivatives in general. Given the large variety of energy products, it is not always evident which derivatives product and which hedging scheme is most effective in reducing exposures. Therefore, proxy hedging is worth a reasonably detailed discussion, taking both an electricity end user and an electricity generator as examples. Finally, the chapter contains a detailed case study of using weather derivatives to hedge exposures resulting from the seasonal and weather-driven demand for energy. It shows that a company’s profit and loss can be directly affected by volume variations, and how weather derivatives assist to mitigate that risk.

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