Energy traders — both in financial and physical markets — face many trials as they enter and exit positions for either speculative or risk management solutions for hedging purposes.
Geopolitical risk has been gaining in prominence, but the complex and often intertwined risks facing traders and risk managers on a day-to-day basis are much more involved. From basis risk to spread, margin and volume risks, operational, contract performance and liquidity risks, there are many metrics facing risk managers as they attempt to hedge against scenarios, and they demand sophisticated computations to determine scenarios to factor against the firm's risk profile.
Even the most advanced risk managers need assistance to quantify and manage the exact risk exposures of the company, let alone a single trade at any one time. Historically, different iterations of value-at-risk (VaR) have developed, with analytical VaR being applied daily and Monte Carlo monthly at most commodity and energy trading houses. With that, quantitative analysts have developed organization-specific risk assessments, which have resulted in varying levels of success.
Testing a hedge's effectiveness is crucial. Even regulators in certain jurisdictions have come to expect regular hedge effectiveness tests, as well as stress tests.
Different markets present different risks, but require the same amount of attention. Exchange-based trading markets — pushed by regulators in recent years — attempt to control risk, and naturally do so with their plethora of rules and participants. Where firms utilize over-the-counter (OTC) mechanisms for hedging — which retains its age-old importance for energy and commodity market participants — risks such as counterparty, liquidity, and default risks are still prominent, and require careful attention.
Counterparty credit risk is a concern for any market participant entering a hedging agreement, and risk managers within energy firms have been aware of the importance of monitoring it since the low oil prices struck. Although prices have recovered, many have remained wary of the need to assess and control counterparty credit risks that grow from market forces. It is difficult territory: many risk managers create counterparty credit risk estimates and assess them with potential future exposure (PFE) estimates, in order to take a view on how a counterparty may be exposed to market conditions. More market participants, however, are turning to energy trading and risk management solutions (ETRMs) to obtain more accurate determinations.
Where trades cross national boundaries, jurisdictions, and currencies, firms rely on risk management solutions to adequately assess and determine currency risk. Currency fluctuations can have a big impact on the value of a trade, and currency risk must be considered to the finest detail. Many ETRMs can evaluate and quantify currency exposures in order to allow managers and traders to better understand and control international exposures.
Of great concern to financial traders and hedgers is the impact of basis risk. This is the risk where the value of a futures (or OTC) contract will not move in line with the underlying exposure. A frequent occurrence, this can be monitored by well-implemented risk management solutions.
For physical hedgers, spread risk can produce different and uncorrelated results. Again, an ETRM system can help mitigate the differentials, and help stabilize transactions.
Market risks can impact a trade by the fundamentals upon which firms rely for arbitrage and hedging opportunities. Margin and volume risks, direct subjects of supply and demand factors of the commodity itself, are made difficult to appraise by the convoluted nature of the energy market.
Impacting many of these risks are concerns regarding market liquidity. The success of a hedge lies in the firm's ability to get in or out of the agreement at the appropriate time, and having deep, active markets is crucial to that. Over the past two decades, energy hedgers have looked more to atypical hedging strategies, and so the need to be able to look into the market and move with knowledge and speed is crucial. That involves instantaneous individual and collective risk assessment, according to the firm's willingness to take risks, and tailored to state-of-the-art quantitative modeling. Therein lies the value in sophisticated risk management solutions.
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