Hedging Effectively: Derivatives For Energy Professionals

Hedging Effectively
Derivatives for Energy Professionals

Kase and Company, Inc.
Session 5
Statistical Review
Copyright Kase and Company, Inc. All rights reserved

THIS PRESENTATION DOWNLOADED FROM WWW.KASECO.COM
Basic Stats
 Mean = The Arithmetic Average
 Median = The Middle Value
 Variance = Sum From 1 To N ((X1-Xm)2+(X2-Xm)2+...(Xn-Xm)2)/(n-1)
 Standard Deviation = Square Root Of Variance 
 Normal Bell Curve
 Random Motion
 Brownian
 Gaussian
 Portfolio Diversification and Covariance

 Risk of Event A OR Event B
 Risk of Event A AND Event B

A Basic Understanding of Statistics
is Necessary to Understand Risk
Assessment and Options
 Volatility is a measure of standard deviation, so it is
proportional to the square root of time (or volume).
 Any math (used for VAR, PAR or forecasts) must be
consistent with market cycle length as the standard
deviation will increase with time asymptotically.
 The higher the standard deviation of a distribution, the
less % movement is needed to hit a particular price, so
options are more expensive at higher volatilities and
longer time frames.

Volatility and Time
In a purely random time series,

volatility is proportional to the
square root of time.
 Quarterly Volatility = Yearly / sqrt(4)

 Monthly Volatility = Yearly / sqrt(12)
 Daily Volatility = Yearly / sqrt(252)
Thus, the longer the risk is held,

the greater its value in absolute
terms.
Normal Distributions
Price Distribution
Distance to Mean
• 1 StdDev = 34%
• 2/3 StdDev = 25%
• 1/2 StdDev = 19%
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 42 44 46 48 50
Price
Low Volatility, StdDev 3 Moderate Volatility, Std Dev 4.5 High Volatility, StdDev 6

Distribution and Standard Deviations
Price Distribution
-3 -2 -1 +1 +2 +3
Tail StdDevs
50 0.000
15 1.033
5 1.645
2.5 1.960
0.1 3.090
10
14
16
18
20
22
24
26
28
30
32
34
38
40
42
44
46
48
12
36
0
2
4
6
8
Moderate Volatility, Std Dev 4.5

Risk = Confidence Level
Price Distribution
-1.96 +1.96
2.5% 2.5%
12
16
18
20
22
24
26
28
30
32
34
36
40
44
46
10
14
38
42
48
0
2
4
6
8
Long Risk Short Risk

Measuring Portfolio Risk
 VAR measures worst expected loss over a given time interval under
defined conditions for a given confidence level.
 Uses similar math as options valuations
 VAR gives a summary measure of market risk
Value at Risk
 difference between the starting price of day 1 and ending price of day n
 standard deviation used to calculate the confidence level
 volatility of the commodity, de-annualized to n days
Example
• Daily VAR of trading portfolio is $2MM at a 99% confidence level
• Means only 1 chance in 100 for a loss greater than $2MM to occur
• Can then decide whether they feel comfortable with this level of risk.

VAR Example
 Let’s assume we buy ten natural gas futures at a price of $2.00
 Futures contract have a volatility of 40% and have 16 days to
expiration.
 We wish to find the VAR
 95% confidence level corresponds to 1.65 standard deviations
 97.5% confidence level corresponds to 1.96 standard deviations.
1. De-annualize the volatility by multiplying the volatility (0.40) by the
square root of (16/256) or 0.25.
2. (0.40)*(  (16/256) = 0.40 * 0.25 = 0.10
3. 97.5% confidence level= (0.10)*(1.96)=0.196 = 0.196*$2.00 = $0.392.
4. 10,000 mmBtu/contract * 10 contracts * $0.392, the VAR is $39,200.

VAR Example, Continued
5. 12 days later, price has moved up by $0.10 to $2.10.
6. Everything else remains unchanged.
7. The volatility on a de-annualized basis is now

(0.40)*(  (4/256), or 0.40*0.125 = 0.05.
8. Thus the VAR on a mark to market basis is

$2.10*0.05*1.96*10*10,000 = 20,580.
9. Considering the “credit” gained, VAR is $20,580 less the

$10,000 gain, or $10,580.

Difficulty in Calculating VAR
 No industry-wide agreement as
 duration
 confidence levels to use
 type of distribution to use
 how to calculate volatility
 Differing approaches to estimating methods.
 Mathematical formulas
 Historical data
 Monte Carlo simulations.

Calculating VAR on Outright Positions
 Use simplified version of Ito’s Lemma.
 Formula employs statistical model of the behavior of functions of
stochastic variables.
 Function was “discovered” by K. Ito in 1951
 Derivation is found in many finance books on derivative theory
K. Ito’s Lemma
Knowing the current price of a commodity, its price growth and its
volatility, Ito’s Lemma can be applied to obtain the probability
distribution of commodity prices on some future date or dates.

The “Lemma” Formula
 For a given confidence level (percent probability):
lnU +(m – n2/2)d – Kd < lnF < lnU +(m – n2/2)d+ Knd
 Where:
 U = the spot price of the commodity

 F = the price of the commodity after d, days
 d = the number of days elapsed
 n = the non annualized price volatility
 m = the growth rate of the commodity price
 K = a nonnegative number, the deviate on a
standardized normal distribution corresponding
to a given confidence level

Lemma Example: Natural Gas
 Assumptions
1. Current position is short
2. , Volatility = 45%
3. U, Starting price = $3.50.
4. m, Bias = zero.
5. K, 95% confidence level, 1.65
6. d, Days = 10 days
 Solving for the price of the underlying after 10 days, P10

P10 = eln(3.50) + (0 - (45% /252)^2) / 2)10 + 1.65(45% / 252)10= $4.04
 VAR = $4.04 - $3.50 = $0.54 per mmBtu.

Plotting Price at Confidence Level
Given the above example, we calculate the following:
Time Elapsed, Days 1 2 3 4 5 10 15 20 25 30
Price Underlying 3.67 3.74 3.79 3.84 3.88 4.04 4.17 4.28 4.38 4.47
VAR -0.17 -0.24 -0.29 -0.34 -0.38 -0.54 -0.67 -0.78 -0.88 -0.97
Price of Commodity versus Time Lapse

Starting @ $3.50, 45% Volatility
4.50
(F) Price of Commodity
4.25
4.00
3.75
3.50
0 5 10 15 20 25 30
Duration of Exposure, Days

Lemma Example,
m=0,  = 5%, U = $5.27
Ito's Lemma, Start from $5.27 @ 45% Volatility
No Bias (Black), Up (Red), Down (Blue)
10.00
Time, Days 5% 95%
9.00 0 5.27 5.27
10 4.52 6.09
8.00
20 4.24 6.45
7.00 30 4.02 6.74
Price
40 3.85 6.98
6.00 50 3.70 7.20
60 3.57 7.40
5.00
4.00
3.00
0 5 10 15 20 25 30 35 40 45 50 55 60 65
Days

Raw Historical Volatility
 The volatility over one day to the next (r), where
“today” is day n =
r = ln (Pn-1/Pn)
 Where:
 r = the day to day rate of change
 P = the price of the underlying
 n = today
Historical Ten Day Volatility =
, over (n-1) values of r

Historical 10-Day Volatility
Date Close ln(B[0]/B[1]) StdDev(C), 9 %,SQRT(252)*D
09/28/00 30.34 n/a n/a n/a
09/29/00 30.71 0.012 n/a n/a
10/02/00 31.86 0.037 n/a n/a
10/03/00 31.85 0.000 n/a n/a
10/04/00 31.24 0.019 n/a n/a
10/05/00 30.54 0.023 n/a n/a
10/06/00 30.91 0.012 n/a n/a
10/09/00 31.85 0.030 n/a n/a
10/10/00 33.07 0.038 n/a n/a
10/11/00 33.24 0.005 0.022 35%
10/12/00 35.72 0.072 0.030 48%
10/13/00 34.13 0.046 0.036 56%
10/16/00 32.39 0.052 0.041 65%
10/17/00 32.42 0.001 0.040 64%
10/18/00 32.47 0.002 0.039 62%
10/19/00 31.9 0.018 0.040 63%
10/20/00 32.95 0.032 0.040 63%
10/23/00 33.76 0.024 0.039 61%
10/24/00 33.37 0.012 0.039 62%
10/25/00 32.96 0.012 0.028 45%
10/26/00 33.71 0.022 0.026 42%
10/27/00 32.74 0.029 0.021 34%
StdDev(ln(Price[1]/Price[0]),9)*SQRT(252)
Average Volatilities
 Volatility on one day may not be representative
 An average or weighted volatility may be better
 Two types of weightings averages
 Weighted
 Exponentially weighted
Weighted Moving Average Volatility

The formula for the weighted moving average is thus:
n n
wtd  ( ii ) /( j )
Where: i 1 j 1
 n = number of days in the calculation

 i = weighting factor (from 1 to n days) for the numerator
 j = weighting factor (from 1 to n days) for the denominator

“Median” Expectations
Ito's Lemma, Start from $5.25 @ 45% Volatility
No Bias (Black), Up (Red), Down (Blue) Expected Prices
In 3 Months, d = 63
8.00
First Nearby, U = $5.25
7.50  = 45%
7.00
6.50
Scenario Price
6.00 Strong Down $3.30
Normal Down $4.50
Price
5.50
5.00 Normal Up $6.60

4.50 Strong Up $8.00
4.00
3.50
3.00
0 5 10 15 20 25 30 35 40 45 50 55 60
Days

Exponentially Weighted Volatility
exponential, n = (2exponential, n+1+ (1 - )r2)
 All the terms are as defined above, and

 Where  = smoothing factor
 And  = 10-3/n
 Smoothing factor, 
 As the number of days increases,  approaches 1.0
 As the number of days declines,  approaches 0
 For 100 days,  is equal to 0 .933
 For 10 days,  is equal to 0.50

Correcting Data to Calculate Volatility
 False Outliers on Rollover Gaps,
 where (n) is the day after rollover
 Historic and the weighted - delete “rn” when (n)
 Exponential - substitute “rn+1” for “rn” when (n).
 Seed Value
 For the exponential, seed value for the initial  is required.
 Use instance of historic volatility calculable after initial 10-day period.
 Variables Used
 For historical volatility, one and three month averages
 Smoothing factors of 0.94 and 0.97 for 112 and 226 days

Annualized Volatility, Last Four Years to 03/01/02
Typical Raw
Value
22 Day
WMA
63 Day
WMA
0.94
EMA.
0.97
EMA
Results of
Average 53 53 53 59 59
StdDev 24 20 17 19 16
Percentile
Volatility Minimum
50
60
15
48
53
23
48
54
28
51
55
29
56
61
33
57
61
Study 70
80
90
61
68
87
62
69
80
60
67
78
66
73
88
66
73
83
95 108 95 82 98 89
Maximum 142 116 107 124 109
10 Day Historical Volatility
Contract Second Fourth Sixth Ninth Twelfth
Average 48 38 31 27 23
StdDev 20 16 15 16 14
Percentile
Minimum 14 7 6 3 2
50 44 35 29 24 20
60 48 39 32 29 24
65 51 42 35 31 28
70 55 44 37 34 30
80 61 52 43 40 35
90 75 59 52 47 42
95 86 67 56 54 49
Maximum 129 88 100 101 74

Correlation, Volatility vs. Trend
Volatility is about the same, independent of degree of trend
Percentile of Trend Volatility Annualized

2.5 0.040 64
5 0.042 67
10 0.038 61
25 0.037 59
50 0.039 62
55 0.035 55
75 0.034 54
95 0.039 62

True Range Proportional
to Volatility with Right Skew
NGM12, Double True Range
Percentiles
0 0.01
350 120%
10 0.04
300 100% 20 0.06
250
80%
30 0.07
40 0.09
Frequency
200
60%
150 50 0.10
100
40% 60 0.12
20%
70 0.14
50
80 0.17
0 0%
0.03 0.04 0.06 0.07 0.09 0.10 0.11 0.13 0.14 0.15 0.17 0.18 0.19 0.21 0.22 0.24 0.25 0.26 0.28 0.29
90 0.22
TRD, mmBtu 100 0.74

Relationship of Volatility
Actual versus Normal Distribution
50
Percentile Ratio
2.5 0.67
40
5 0.70
10 0.79
15 0.84
30 20 0.92
25 1.03
30 1.16
35 1.36
40 1.75
20
45 2.70
50 0.00
45 -1.15
40 -0.12
10
35 0.33
30 0.52
25 0.68
20 0.86
0
15 0.96
-2.00
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
10 1.11
5 1.18
2.5 1.29

Monte Carlo Simulations
 Controlled statistical sampling
 “random” works better than
 “hypercube”
 Generates possible realizations of a system
 Uses probability distributions and their relationships
 Involves using random numbers
 Samples many different paths underlying could follow….
Pe rpe tual Price Expectation, No Bias
Probability
1.0 1.2 1.7 2.1 2.6 3.0 3.5 3.9 4.4 4.8 5.3 5.7 6.2 6.6 7.1 7.5 8.0 8.4 8.9 9.3 10.0
Price

“Real Life” Example
Run during the 4Q00 for First Nearby Contract
Percentile No Bias Weak Up Normal Up Strong Up

5 6.17 6.17 7.66 7.82
20 7.26 7.35 8.80 9.56
25 7.52 7.60 9.04 9.95
50 8.60 8.86 10.13 11.84
75 9.90 10.27 11.42 14.09
80 10.24 10.67 11.77 14.67
95 12.06 12.65 13.34 17.70

Price Distributions
and Mean Reversion
 Random processes form normal bell curves.
 Comparison of Normal to Empirical about same.
 Longer strips tend to form (more or less) log normal
distributions.
 Prices mean revert but the mean may be trending.
 Challenges are
 Market may have multiple embedded cycles.
 Determining which mean to use.

Distributions of Actual to
Standard Curve
Standard Curve 250 Dev 999 Dev
% All Crude Gas
50
2.5 -15 -14 -9
5 -10 -8 -2
10 -8 -11 5
40
20 -1 -7 9
30 3 -1 7
40 16 24 14
30
50 -27 91 -55
60 -45 -56 -65
70 -26 -33 -39
80 -13 -19 -6
20
90 -11 -28 -3
95 12 16 5
97.5 13 16 7
10
0
2.50
0.00
0.50
1.00
1.50
2.00
-2.50
-2.00
-1.50
-1.00
-0.50


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Hedging Effectively

Derivatives for Energy Professionals

Copyright Kase and Company, Inc. All rights reserved

 Portfolio Diversification and Covariance

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

In a purely random time series,

 Quarterly Volatility = Yearly / sqrt(4)

Thus, the longer the risk is held,

Copyright Kase and Company, Inc. All rights reserved

Moderate Volatility, Std Dev 4.5

Copyright Kase and Company, Inc. All rights reserved

Long Risk Short Risk

Copyright Kase and Company, Inc. All rights reserved

4. 10,000 mmBtu/contract * 10 contracts * $0.392, the VAR is $39,200.

6. Everything else remains unchanged.

7. The volatility on a de-annualized basis is now

8. Thus the VAR on a mark to market basis is

9. Considering the “credit” gained, VAR is $20,580 less the

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

 U = the spot price of the commodity

Copyright Kase and Company, Inc. All rights reserved

 Solving for the price of the underlying after 10 days, P10

Copyright Kase and Company, Inc. All rights reserved

Price of Commodity versus Time Lapse

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

, over (n-1) values of r

Weighted Moving Average Volatility

 n = number of days in the calculation

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5.00 Normal Up $6.60

Copyright Kase and Company, Inc. All rights reserved

 All the terms are as defined above, and

 As the number of days declines,  approaches 0

 For 100 days,  is equal to 0 .933

 For 10 days,  is equal to 0.50

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

Copyright Kase and Company, Inc. All rights reserved

Percentile of Trend Volatility Annualized

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Percentile No Bias Weak Up Normal Up Strong Up

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% All Crude Gas

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