Beyond Essentials Option Applications in Energy
This course is appropriate for professionals wishing to obtain a solid practical and conceptual (non-quantitative) understanding of more sophisticated option concepts as they apply specifically to the energy business. This is not an introductory options program. Participants should be familiar with basic option concepts. Optionality seen in the energy business is different in many aspects from options on stocks and bonds. Emphasis is placed on the unique dimensions of the energy business and how they influence option valuations and hedge implementation. The program includes a wide array of option structures. These are important for the energy professional, not just because they can represent efficient tools to hedge existing risks. However, more significantly, almost all of these forms of optionality can be found embedded either in energy assets or supply contracts. Awareness of the nature of the risks inherent in these embedded positions and the values associated with them, is critical to efficient management throughout the energy sector.
CPE Credits: Accounting & Auditing 2, Consulting Services 1, Management 1, Specialized Knowledge & Applications 12.
Day 1
Concepts Underlying Optionality in Energy

• Options and the forward price curve
• Risk Identification
• Relationship between Index and physical energy
• Basic put/call structures and payouts
• Options embedded in contracts and energy assets
• Option vs. fixed-price hedging strategies
• Identifying options embedded in transactions and physical assets

Arbitrage Discipline in Option Pricing

• Intrinsic and time (extrinsic) value
• European vs. American options
• Storage as an embedded component of certain American Options
• Option premium arbitrage
• Put call parity
• Creating synthetic puts and calls
• Arbitraging miss-priced options
• Parity’s applications in analysis, financial reporting and deal structuring
• Structure of time value
• Volatility smiles and skews in energy options
• Structuring implications of skews

Option Pricing Models in Energy

• What option models do and don’t do
• How pricing energy options differs from pricing stock options
• Assumptions underlying models
• Limitations and implications
• Understanding option pricing parameters
• The option premium: forecast of hedging costs vs. expected payout

Understanding Volatility

• Types of volatility
• Measuring volatility
• Interpreting volatility
• Role of holding period in volatility measure
• Term structure of volatility
• How volatility structures in energy differ from financial markets
• Interpretation of volatility by option models

Delta Hedging

• Creating neutrality to directional price moves
• Isolating volatility risk from directional price risk
• Calculating the delta value
• Delta as a hedge ratio
• Delta as a statistical measure of the likelihood of option exercise
• How option values change as the price of the underlying changes
• Positive vs. negative delta values
• Implications of delta to the option trader
• Implications of delta to a non-trader

Cost of Adjusting Delta

• Dynamic hedging
• Need to adjust the hedge
• Cost of each hedge adjustment
• Variability of hedge adjustment costs
• Constraints on delta hedging in the energy markets
Day 2

• Measuring the cost of delta hedge adjustments
• Calculating gamma
• Importance to the option trader
• Interpreting gamma
• Positive vs. negative gamma
• The profile of gamma and relationship to time value
• Implications of gamma to volatility smiles and skews

Portfolio Aggregation Option Risk

• Portfolio aggregation of Delta
• Need to segregate position into “time buckets”
• Interpreting portfolio delta
• Managing aggregated portfolio gamma positions
• Need for stress testing

Theta, Vega & Rho

• Theta as the offset to gamma
• The decay of time value
• Differentiating exposure to implied vs. actual price volatility (Vega vs. Gamma)
• How rho differs in energy options compared to financial (non-energy) options
• Differentiate time value of money vs. time value of options

Complex Optionality Common in Energy

“Exotic” Optionality

• Defining an “exotic” option
• Non-standard (“exotic”) optionality embedded in energy contracts
• Non-standard optionality embedded in energy assets
• Advantages of exotic options as a risk management tool
• Minimizing hedge costs by avoiding “overhedging”

Path-Dependent Options

• Asian options
• Barrier options
• Hedge structuring using knock-in’s knock-out’s
• Advantages of path-dependent options
• Path-dependent options common in the energy business

Digital Options

• Binary structures
• Valuing a digital option
• Structuring using digitals
• Digital options embedded in energy operations
• Force majeure as a digital risk

Multiple-Fuel Options

• The role of correlation in valuing multi-fuel options
• Basket options
• Spread options: options on basis, calendar, & spark spreads
• Rainbow options
• Dispatch options
• Multi-fuel options contained in common energy contracts

Optionality Embedded in Energy Assets and Operations

• Pipeline optionality
• Storage optionality
• Extrinsic value in generation
• Option-based asset valuation vs. conventional DCF approach

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