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Julie,
No problem. It's your call but Chris should also be mentioned as number one. Vince "Julie" <julie@lacima.co.uk< on 08/03/2000 03:06:28 PM To: "Vince J Kaminski" <Vince.J.Kaminski@enron.com< cc: Subject: Re: Preface for book Vince, Thanks for this.?? ? Are you OK with us using your name for this?? ? Julie ----- Original Message ----- From: Vince J Kaminski To: julie@lacima.co.uk Sent: Wednesday, August 02, 2000 2:11 PM Subject: Re: Preface for book ---------------------- Forwarded by Vince J Kaminski/HOU/ECT on 08/02/2000 08:16 AM --------------------------- Vince J Kaminski 08/02/2000 08:09 AM To:?? "Julie" <julie@lacima.co.uk< @ ENRON cc:?? Vince J Kaminski/HOU/ECT@ECT, Grant Masson/HOU/ECT@ECT Subject:? Re: Preface for book? (Document link: Vince J Kaminski) Julie, The introduction looks fine. I have made some cosmetic changes (typos and split infinitives that slipped by). You can safely ignore most of them. English is not even my second language. The corrections are in pink. Vince (See attached file: Intro0802.doc) "Julie" <julie@lacima.co.uk< on 08/01/2000 07:43:10 AM To:?? "VinceJKaminski" <Vince.J.Kaminski@enron.com< cc: Subject:? Preface for book Vince, Hope you are well. We spoke a while ago about who should write the preface for the book, and? you kindly offered that you would provide this. Is this still? possible? We realise that you are extremely busy, so Chris and Les went? ahead and wrote something, which is below, and if you want to review, change or? re-write the preface, that would be very appreciated. Let me know? what your thoughts are. Thanks, Julie (we're getting close) Preface One of our main objectives in? writing Energy Derivatives: Pricing and Risk Management has been to bring? together as many of the various approaches for the pricing and risk management? energy derivatives as possible, to discuss in-depth the models, and to show how? they relate to each other. In this? way we hope to help the reader to analyse the different models, price a wide? range of energy derivatives, or to build a risk management system which uses a? consistent modelling framework. We? believe that for practitioners this last point is very important and we continue? to stress in our articles and presentations the dangers of having flawed risk? management and giving arbitrage opportunities to your competitors by using? ad-hoc and inconsistent models for different instruments and markets (see also OTHERS WHO PROPOSE CONSISTENT? MODELS?). However, it is not? our wish to concentrate on one particular model or models, at the exclusion of? the others because we believe that the choice should rest with the user? (although it will probably be clear from our discussions the model(s) we? prefer). We therefore try and give? as clear account as possible of the advantage and disadvantages of all the? models so that the reader can make an informed choice as to the models which? best suit their needs. In order to meet our objectives the? book is divided into 11 chapters. ? In chapter 1 we give an overview of the fundamental principals needed to? model and price energy derivatives which will underpin the remainder of the? book. In addition to introducing? the techniques that underlie the Black-Scholes modelling framework we outline? the numerical techniques of trinomial trees and Monte Carlo simulation for? derivative pricing, which are used throughout the book. In Chapter 2 we discuss the? analysis of spot energy prices. As? well as analysing empirical price movements we propose a number of processes? that can be used to model the prices. ? We look at the well-know process of Geometric Brownian Motion as well as? mean reversion, stochastic volatility and jump processes, discussing each and? showing how they can be simulated and their parameters estimated. Chapter 3, written by Vince? Kaminski, Grant Masson and Ronnie Chahal of Enron Corp., discusses volatility? estimation in energy commodity markets. ? This chapter builds on the previous one. It examines in detail the methods,? merits and pitfalls of the volatility estimation process assuming different? pricing models introduced in chapter 2. ? Examples from crude, gas, and electricity markets are used to illustrate? the technical and interpretative aspects of calculating volatility. Chapter 4 examines forward curves? in the energy markets. Although? such curves are well understood and straight-forward in the most financial? markets, the difficulty of storage in many energy markets leads to less well? defined curves. In this chapter we? describe forward price bounds for energy prices and the building of forward? curves from market instruments. We? outline the three main approaches which have been applied to building forward? curves in energy markets; the arbitrage approach, the econometric approach, and? deriving analytical values by modelling underlying stochastic factors. Chapter 5 presents an overview of? structures found in the energy derivative markets and discusses their uses. Examples of products analysed in this chapter include a variety of swaps, caps, floors and collars, as well as energy swaptions, compound options, Asian options, barrier options, lookback options, and ladder options. Chapter 6 investigates single and? multi-factor models of the energy spot price and the pricing of some standard? energy derivatives. Closed form? solutions for forward prices, forward volatilities, and European option prices? both on the spot and forwards are derived and presented for all the models in? this chapter including a three factor, stochastic convenience yield and interest rate model. Chapter 7 shows how the prices of? path dependent and American style options can be evaluated for the models in? Chapter 6. Simulation schemes are? developed for the evaluation of European style options and applied to a variety? of path dependent options. In order? to price options which incorporate early exercise opportunities, a trinomial? tree scheme is developed. This tree? is built to be consistent with the observed forward curve and can be used to? price exotic as well as standard European and American style options. Chapter 8 describes a methodology? for valuing energy options based on modelling the whole of the market observed? forward curve. The approach results? in a multi-factor model that is able to realistically capture the evolution of a wide range of energy forward curves. ? The user defined volatility structures can be of an extremely general? form. Closed-form solutions are? developed for pricing standard European options, and efficient Monte Carlo? schemes are presented for pricing exotic options. The chapter closes with a discussion of the valuation of American style options. Chapter 9 focuses on the risk? management of energy derivative positions. ? In this chapter we discuss the management of price risk for institutions? that trade options or other derivatives and who are then faced with the problem? of managing the risk through time. ? We begin with delta hedging a portfolio containing derivatives and look? at extensions to gamma hedging ? illustrating the techniques using both spot and? forward curve models. The general? model presented in Chapter 8 is ideally suited to multi-factor hedging of a? portfolio of energy derivatives and this is also discussed. Chapter 10 examines the key risk? management concept of Value at Risk (VaR) applied to portfolios containing? energy derivative products. After? discussing the concept of the measure, we look at how the key inputs? (volatilities, covariances, correlations, etc) can be estimated. We then compare the fours major? methodologies for computing VaR; Delta, Delta-gamma, historical simulation and? Monte-Carlo simulation, applying each to the same portfolio of energy? options. In this chapter we also? look at testing the VaR estimates for various underlying energy market? variables. Finally, in Chapter 11 we review? modelling approaches to credit risk. ? We look in detail at two quite different approaches, CreditMetrics (J. P. Morgan (1997)) and? CreditRisk+ (Credit Suisse Financial? Products (1997)) for which detailed information is publicly available. Together these provide an extensive set? of tools with which to measure credit risk. We present numerical examples of applying these techniques to energy derivatives. Before? we begin we stress that the models and methods we present in this book are tools? which should be used with the benefit of an understanding of how both the ?tool?? and the market works. The? techniques we describe are certainly not ?magic wands? which can be waved at? data and risk management problems to provide instant and perfect solutions. To quote from the RiskMetrics Technical Document ?? no amount of sophisticated analytics will replace experience and professional judgement in managing risk.?. ? However, the right tools, correctly used make the job a lot? easier!
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