Sjur Westgaard Vol Qreg Var

Value at Risk Modelling for Energy Commodities
using Volatility Adjusted Quantile Regression

CRUDEOIL
1,200
120
el-UK-M
NATURALGAS
GASOIL
140
el-UK-Q
140
90
100
70
120
80
90
60
100
70
80
60
60
50
40
40
1,000
100
800
60
60
40
600
80
70
50
80
50
30
40
400
20
200
IV I II III IV I II III IV I II III IV I II III IV I II III

2009
2010
2011
2012
2013
40
20
20
10
2009
2010
2011
2012
2013
30
2009
2010
2011
2012
2013

2009
2010
2011
2012
2013
30
2009
2010
2011
2012
2013
el-Ned-Q
COAL
140
CARBON
el-Ger-Q
90
30
90
80
80
25
80
70
70
60
60
50
50
40
40
30
70
60
15
10
80
5
30

2009
2010
2011
2012
2013
50
40
20
2009
2010
2011
2012
2013
0
2009
2010
2011
2012
2013
el-Ger-M
90
20
60

2009
2010
2011
2012
2013
100
120
100
el-Ned-M
80
30
2009
2010
2011
2012
2013
el-Nor-M
100

2009
2010
2011
2012
2013
el-Nor-Q
90
80
80
70
60
60
50
40
40
20
30
20
2009
2010
2011
2012
2013

2009
2010
2011
2012
2013
Energy Finance Conference

Essen Thursday 10th October 2013
Sjur Westgaard
Email: sjur.westgaard@iot.ntnu.no
Tel: 73593183 / 91897096
Web: www.iot.ntnu.no/users/sjurw
Department of Industrial Economics
Norwegian University of Science and Technology
Professor Sjur Westgaard

Department of Industrial Economics and Technology Management,
Norwegian University of Science and Technology (NTNU)
Alfred Getz vei 3, NO-7491 Trondheim, Norway
www.ntnu.no/iot
Mail: sjur.westgaard@iot.ntnu.no
Phone: +47 73598183 or +47 91897096
Sjur Westgaard is MSc and Phd in Industrial Economics from Norwegian University of Science
and Technology and a MSc in Finance from Norwegian School of Business and Economics. He has
worked as an investment portfolio manager for an insurance company, a project risk manager for
a consultant company and as a credit analyst for an international bank. His is now a Professor at
the Norwegian University of Science and Technology and an Adjunct Professor at the Norwegian
Center of Commodity Market Analysis UMB Business School. His teaching involves corporate
finance, derivatives and real options, empirical finance and commodity markets. His main research
interests is within risk modelling of energy markets and he has been a project manager for two
energy energy research projects involving power companies and the Norwegian Research Consil.
He has also an own consultancy company running executive courses and software implementations
for energy companies. Part of this work is done jointly with Montel.
Trondheim
Trondheim
www.montelpowernews.com
Montel Online
Up-to-theminute news
Live price
feeds European
Energy Data
Price-driving
fundamentals
Financial /
weather data
Excel-addin
historical data
Courses and
Seminars
Why Value at Risk Modelling for Energy Commodities using Volatility Adjusted Quantile
Regression?
From Burger et al. (2008)*:

Liberalisation of energy markets (oil, gas, coal, el,
carbon) has fundamentally changed the way power
companies do business
Competition has created both strong incentives for
improving operational efficiency and as well as the
need for effective financial risk management
* Burger, M., Graeber B.,
Schindlmayr, G. 2008, Managing
energy risk An integrated view on
power and other energy markets,
Wiley.
Why Value at Risk Modelling for Energy Commodities using Volatility Adjusted Quantile
Regression?
More volatile energy markets and complex trading/hedging portfolios
(long
and short positions) has increased the need for measuring risk at
Individual contract level
Portfolio of contracts level
Enterprise level
Understanding the dynamics and determinants of volatility and risk

(e.g. Value at Risk and Expected Shortfall) for energy commodities are
therefore crucial.
We therefore need to correctly model and forecast the return
distribution for energy futures markets
Why Value at Risk Modelling for Energy

Commodities using Volatility Adjusted
Quantile Regression?
Oil/GasOil/Natural Gas/Coal/Carbon/Electricity from ICE, EEX, Nasdaq
OMX shows:
Conditional return distributions various across energy commodities
Conditional return distributions for energy commodities varies over time
This makes risk modelling of energy futures markets very challenging!

The problems with existing standard risk model (that many energy
companies have adopted from the bank industry) are:
RiskmetricsTM VaR capture time varying volatility but not the
conditional return distribution
Historical Simulation VaR capture the return distribution but not
the time varying volatility
Alternatives:
GARCH with T, Skew T, or GED
CaViaR type models
Although these models works fine according to several studies, there is
a problem of calibrating these non-linear models and therefore they are
only used to a very limited extent in practice

In this paper we propose a robust and easy to implement approach for
Value at Risk estimation based on;
First running an exponential weighted moving average volatility
model (similar to the adjustment done in RiskmetricsTM) and then
Run a linear quantile regression model based on this conditional
volatility as input/explanatory variable
The model is easy to implement (can be done in a spreadsheet)
This model also shows an excellent fit when backtesting VaR
10
Measuring Value at Risk / Quantiles

el-Ger-Q
90
Loss for a consumer or

trader having a short position in German
front Quarter Futures.
80
70
60
Loss for a producer or

trader having a long position in German
front Quarter Futures.
50
40
30
IV
II
III
IV
2009
II
III
IV
2010
II
III
IV
2011
II
III
IV
2012
II
III
2013
200
160
One important task is to model and forecast the

upper and lower tail of the price distribution
using standard risk measures such as Value at
Risk and Conditional Value at Risk for different
quantiles (e.g. 0.1%, 1%, 5%, 10%, 90%, 95%,
99%, 99.9%).
120
Oil prices ($/Ton)
80
40
0
30
35
40
45
50
55
60
65
70
75
80
85
90
11
Layout for the presentation

Previous work/literature of risk modelling of (energy) commodities
European Energy Futures Markets (crude oil, gas oil, natural gas, coal,
carbon, and electricity) and Data/Descriptive Statistics
ICE
ICE-ENDEX
EEX
Nasdaq OMX Commodities
Volatility Adjusted Quantile Regression
Comparing / Backtesting Value at Risk analysis for Energy Commodities
RiskMetricsTM
Historical Simulation
Conclusions and further work
12
Literature
Value at Risk analysis for energy and
other commodities::
Andriosopoulos and Nomikos (2011)
Aloui (2008)
Borger et al (2007)
Bunn et al. (2013)
Chan and Gray (2006)
Cabedo and Moya (2003)
Costello et al. (2008)
Fuss et al. (2010)
Giot and Laurent (2003)
Hung et al. (2008)
Mabrouk (2011)
Quantile regression in general and applications in

financial risk management:
Alexander (2008)
Engle and Manganelli (2004)
Hao and Naiman (2007)
Koenker and Hallock (2001)
Koenker (2005)
Taylor (2000, 2008a, 2008b,2011)
We want to fill the gap in the literature

by performing Value at Risk analysis for
European Energy Futures using volatility
adjusted quantile regression.
Discussion weaknesses RiskMetrics and

Historical Simulation during Financial
Crises
Sheedy (2008a, 2008b)
13
Literature
TEXTBOOKS ENERGY MARKET MODELLING
Bunn D., 2004, Modelling Prices in Competitive Electricity Markets , Wiley
Burger, M., Graeber B., Schindlmayr, G. 2008, Managing energy risk An integrated view
on power and other energy markets, Wiley.
Eydeland A. and Wolyniec K., 2003, Energy and power risk management, Wiley
Geman H., 2005, Commoditites and commodity derivatives Modelling and pricing for
agriculturas, metals and energy, Wiley
Geman H., 2008, Risk Management in commodity markets From shipping to agriculturas and
energy, Wiley
Kaminski V., 2005, Managing Energy Price Risk The New Challenges and Solutions , Risk
Books
Kaminski V., 2005, Energy Modelling, Risk Books
Kaminski V., 2013, Energy Morkets, Risk Books
Pilipovic D., 2007, Energy risk Valuation and managing energy derivatives , McGrawHill
Serletis A., 2007. Quantitative and empirical analysis of energy markets , Word Scientific
Weron R., 2006, Modeling and Forecasting Electricity Loads and Prices: A Statistical
Approach, Wiley
14
European Energy Futures and Options Markets
ICE: www.theice.com
ICE-ENDEX: www.iceendex.com
EEX: www.eex.com
Nasdaq OMX commodities: www.nasdaqcommodities.com
15
16
Data and descriptive statistics

Front Futures Contracts
CRUDEOIL
GASOIL
140
1,200
120
1,000
100
800
80
60
600
40
400
20
2009
2010
2011
2012
2013
200
2009
2010
2011
2012
2013
17

Front Futures Contracts
COAL
NATURALGAS
140
80
70
120
60
50
100
40
30
80
20
60
10
2009
2010
2011
2012
2013

2009
2010
2011
2012
2013
18

Phase II Dec 2013 Futures Contract
CARBON
30
25
20
15
10
0
IV
II
III
2009
IV
II
III
2010
IV
II
III
2011
IV
II
III
2012
IV
II
III
2013
19

UK Base Front Month and Quarter Futures Contracts
140
120
100
80
60
40
20
IV
II
III
2009
IV
II
III
IV
2010
II
III
IV
2011
el-UK-M
II
III
2012
IV
II
III
2013
el-UK-Q
20

Dutch Base Front Month and Quarter Futures Contracts
100
90
80
70
60
50
40
30
IV
II
III
2009
IV
II
III
IV
2010
II
III
IV
2011
el-Ned-M
II
III
2012
IV
II
III
2013
el-Ned-Q
21

German Base Front Month and Quarter Futures Contracts
90
80
70
60
50
40
30
20
IV
II
III
2009
IV
II
III
IV
2010
II
III
IV
2011
el-Ger-M
II
III
2012
IV
II
III
2013
el-Ger-Q
22

Nordic Base Front Month and Quarter Futures Contracts
100
90
80
70
60
50
40
30
20
10
IV
II
III
2009
IV
II
III
IV
2010
II
III
IV
2011
el-Nor-M
II
III
2012
IV
II
III
2013
el-Nor-Q
23

Returns are calculated as relative price changes
ln(Pt/Pt-1) for crude oil, gas oil, natural gas, coal,
carbon, month and quarter base contracts for UK,
Nederland, Germany, and the Nordic market
Returns when contract rolls over are deleted
24

Mean, Stdev, Skew, Kurt, Min, Max, Empirical 5% and 95% quantiles
are estimated for all series in the following periods:
13Oct2008 to 30Dec2008
2009
2010
2011
2012
02Jan2013 to 30Sep2013
13Oct2008 to 30Sep2013
Questions in mind:
How do return distributions varies across energy
commodities?
How do energy commodity distributions changes over time?
25
Example of analysis: German and Nordic Rolling Base Front Quarter Contracts
26

High return volatility for energy commodities. Annualized values much
higher than for stocks and currency markets, specially for short term
natural gas and electricity contracts
Fat tails for all energy commodities. Some energy commodities have
mainly negative skewness (e.g. crude oil), others positive (e.g natural
gas)
Return distribution of energy commodities varies a lot over time,
hence the evolution of empirical VaR over time
Risk modeling of energy commodities will be very

challenging. Need models that capture the dynamics
of changing return distribution over time
27
Quantile regression
Quantile
regression was introduced by a paper

in Econometrica with Koenker and Bassett
(1978) and is fully described in books by
Koenker (2005) and Hao and Naiman (2007)
Applications in financial risk management
(stocks / currency markets) can be found by
Engle and Manganelli (2004), Alexander (2008),
Taylor (2008)
28
28
Quantile regression
0.1, 0.5, and 0.9

quantile regression
lines.
Yqt = q+qXt+qt
The lines are found by

the following
minimizing the
weighted absolute
distance to the qth
regression line:
0.15
0.1
0.05
0
Min (q 1Yt X t )(Yt ( X t ))

,
t 1
where
-0.05
1
0
1Yt X t
-0.1
-0.15
-0.15
-0.1
-0.05
0.05
0.1
0.15
if Yt X t
otherwise
29
29

1) Calculate Exponentially Weighted Moving Average of
Volatility
2) Run a Quantile Regression Regression with the
Exponentially Weighted Moving Average of Volatility as
the explanatory variable
3) Predict the VaRqt+1 from the model
30
Returns and EWMA Volatility

Example El_Ger_Q
This is just an Excel illustration.

Qreg procedures in R, Stata,
Eviews etc. should be used
instead
31
31

Example GasOil
.12
.08
GASOIL
.04
.00
-.04
-.08
-.12
.00
.01
.02
.03
.04
.05
VOL_GASOIL
32

Example GasOil Distribution forecast from volatility
adjusted quantile regression
Todays EWMA vol is 2% on a daily basis.
What is 5%, 95% 1 day VaR given our
model?
Var5% = -0.006589 % - 1.290804*2% = -2.59%
Var5% = -0.002108 % + 1.817529 *2% = 3.63%
Similar equations are found for all the
quantiles
33
Comparing Value at Risk models

for energy commodities
VaR Models
RiskMetricsTM
Backtesting Value at Risk Models

Kupiec Test
Christoffersen Test
34

It is easy to estimate VaR once we have the return
distribution
The only difference between the VaR models are
due to the manner in which this distribution is
constructed
35

RiskMetricsTM
Analytically tractable, adjustment for timevarying volatility, but assumption of normally
distributed returns for energy commodities is
not suitable
36
RiskMetricsTM
VaR=-1()*t
Volatility changes dynamically over time and needs to be
updated. For this reason many institutions use an exponentially
weighted moving average (EWMA) methodology for VaR
estimation, e.g. using EWMA to estimate volatility in the
normal linear VaR formula
These estimates take account of volatility clustering so that
EWMA VaR estimates are more risk sensitive
37
Example:
RiskMetricsTM for gasoil
38

Historical simulation
Makes no assumptions about the parametric
form of the return distribution, but do not
make the distribution conditional upon market
conditions / volatility
39
1. Choose a sample size to reflect current market
conditions (Banks usually use 3-5 years)
2. Draw returns from the empirical distribution
and calculate VaR for each simulation
3. Use the average VaR for all simulation (you alsp
get the distribution of VaR as an outcome)
Also called bootstrapping

40
Example:
Historical Simulation for gasoil
41

Allows for all kinds of distributions (semi nonparametric method) and allow the distribution
to be conditional upon the volatility/changing
market condition
42

1) Calculate Exponentially Weighted Moving Average of
Volatility
2) Run a Quantile Regression Regression with the
Exponentially Weighted Moving Average of Volatility as
the explanatory variable
3) Predict the VaRqt+1 from the model
43
Example:
Vol-adjusted QREG for gasoil
44
Backtesting VaR Models

In sample analysis
Backtesting refers to testing the accuracy of a VaR

model over a historical period when the true
outcome (return) is known
The general approach to backtesting VaR for an

asset is to record the number of occasions over the
period when the actual loss exceeds the model
predicted VaR and compare this number to the prespecified VaR level
45
Example Front Quarter Futures Nordic
46

A proper VaR model has:
The number of exceedances as close as
possible to the number implied by the VaR
quantile we are trying to model
Exceedances that are randomly
distributed over the sample (that is no
clustering of exceedances). We do not
want the model to over/under predict VaR
in certain periods
47
To validate the predictive performance of the models,

we consider two types of test:
The unconditional test of Kupiec (1995)
The conditional coverage test of Christoffersen

(1998)
Kupiec (1995) test whether the number of exceedances
or hits are equal to the predefined VaR level.
Christoffersen (1998) also test whether the
exceedances/hits are randomly distributed over the
sample
48
Backtesting Value at Risk

Models Kupiec Test
The Kupiec (1995) test is a likelihood ratio test
designed to reveal whether the model provides the
correct unconditional coverage.
More precisely, let Ht be a indicator sequence where Ht
takes the value 1 if the observed return, Yt, is below
the predicted VaR quantile, Qt, at time t
1 if Yt Qt
Ht
0 if Yt Qt
49

Models Kupiec Test
Under the null hypothesis of correct unconditional
coverage the test statistic is
2ln LRuc 2 n0 ln 1
exp
nln
1
exp
nln

0 1
ln
obs n
1
obs
1
Where n1 and n0 is the number of violations and nonviolations respectively, exp is the expected proportion
of exceedances and obs = n1/(n0+n1) the observed
proportion of exceedances.
50

Models Christoffersen test
In the Kupiec (1995) test only the total number of

ones in the indicator sequence counts, and the test
does not take into account whether several quantile
exceedances occur in rapid succession, or whether
they tend to be isolated.
Christoffersen (1998) provides a joint test for

correct coverage and for detecting whether a
violations are clustered or not.
51

Models Christoffersen test
The test statistic is defined as follows:
where nij represents the number of times an observations with value i

is followed by an observation with value j (1 is a hit, 0 is no hit).
01=n01/(n00+n01) and 11=n11/(n11+n10). Note that the
LRcc test is only sensible to one violation immediately followed by
other, ignoring all other patterns of clustering. There has now been
established tests that test for other forms of patters.
52
Kupiec (95) and Christoffersen (98) tests

53

Model Comparison
54
54

Model Comparison
Preliminary results show:
RiskMetricsTM capture the conditional coverage for crude oil, gas oil,
natural gas, coal, carbon but not for most of electricity contracts.
Historical Simulation gives a better unconditional coverage but fails
(largely) on the unconditional coverage (exceedances are clustered)
Volatility Adjusted Quantile Regression gives the best unconditional
and conditional coverage. For some of the electricity contracts there
are some indication of clustering of exceedances though.
55
55
Conclusion
Stylized facts shows that European Energy Futures returns have
very different dynamics regarding the return distribution.
For a given energy commodity, the conditional distribution changes
over time.
RiskmetricsTM most of the volatility dynamics but not the
distribution. Historical Simulation capture the unconditional
distribution but not the volatility dynamics. Volatility Adjusted
Quantile Regression capture to a large extend both properties as the
distribution is made conditional upon volatility/market conditions.
56
56
Further Work
Non-Linear Copula Quantile Regression for investigating the
returns-volatility relationship following ideas of Alexander
(2008)
Multivariate risk analysis for portfolios (e.g. many electricity
futures contracts) using Borger et al (2007) as a starting
point. One idea is to apply the following setup:
1. First run Principal Component Analysis for the factors
2.
3.
Then run volatility filtering (e.g. EWMA) on the components

Then run Quantile Regression on the filtered components
57
Questions?
Mail: sjur.westgaard@iot.ntnu.no
Phone: +47 73598183 or +47 91897096
58

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Value at Risk Modelling for Energy Commodities

using Volatility Adjusted Quantile Regression

IV I II III IV I II III IV I II III IV I II III IV I II III

IV I II III IV I II III IV I II III IV I II III IV I II III

IV I II III IV I II III IV I II III IV I II III IV I II III

IV I II III IV I II III IV I II III IV I II III IV I II III

IV I II III IV I II III IV I II III IV I II III IV I II III

IV I II III IV I II III IV I II III IV I II III IV I II III

Energy Finance Conference

Professor Sjur Westgaard

From Burger et al. (2008)*:

More volatile energy markets and complex trading/hedging portfolios

Understanding the dynamics and determinants of volatility and risk

Why Value at Risk Modelling for Energy

This makes risk modelling of energy futures markets very challenging!

Why Value at Risk Modelling for Energy

Why Value at Risk Modelling for Energy

Measuring Value at Risk / Quantiles

Loss for a consumer or

Loss for a producer or

One important task is to model and forecast the

Layout for the presentation

Quantile regression in general and applications in

We want to fill the gap in the literature

Discussion weaknesses RiskMetrics and

European Energy Futures and Options Markets

Data and descriptive statistics

Data and descriptive statistics

IV I II III IV I II III IV I II III IV I II III IV I II III

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Data and descriptive statistics

Risk modeling of energy commodities will be very

regression was introduced by a paper

0.1, 0.5, and 0.9

The lines are found by

Min (q 1Yt X t )(Yt ( X t ))

Volatility Adjusted Quantile Regression

Returns and EWMA Volatility

This is just an Excel illustration.

Returns and EWMA Volatility

Returns and EWMA Volatility

Comparing Value at Risk models

Backtesting Value at Risk Models

Comparing Value at Risk models

Comparing Value at Risk models

Comparing Value at Risk models

Also called bootstrapping

Comparing Value at Risk models

Volatility Adjusted Quantile Regression

Backtesting VaR Models

Backtesting refers to testing the accuracy of a VaR

The general approach to backtesting VaR for an

Backtesting VaR Models

Example Front Quarter Futures Nordic

Backtesting Value at Risk Models

Backtesting VaR Models

To validate the predictive performance of the models,