This issue of The Journal of Energy Markets has a strong financial theme. Energy markets create special challenges for derivative pricing, yet few other sectors can rival energy for the practical benefits that advanced methods can provide. We have three papers on the applicability of derivative pricing, and one looking at the topical theme of financial market spillovers from oil price shocks.
This first paper in this issue, "Pricing and hedging quanto options in energy markets" by Fred Espen Benth, Nina Lange and Tor Åge Myklebust, looks at an increasingly useful class of derivatives in energy markets. The payoffs from these options are typically written on both an underlying energy index and a measure of temperature. As such, they are well-suited for managing the joint price and volume risk in energy markets. The authors derive a closed-form option pricing formula, under the assumption that the underlying assets are lognormally distributed. The approach encompasses geometric Brownian motion as well as multifactor spot models, and the authors derive delta and gamma expressions for hedging. They illustrate its use with NYMEX traded natural gas futures and CME traded heating degree days futures for New York.
Also on the topic of energy derivatives, the issue's second paper, "A construction of volatility surfaces for futures markets" by Qimou Su, Ni Xiao and Curt Randall, describes a practical approach to constructing arbitrage-free volatility surfaces that are consistent with the observed options smiles and Samuelson effect in futures markets. They use data from NYMEX WTI oil to demonstrate the algorithm. A separate volatility surface is created for each futures contract. The algorithm is fast and robust and its ability to match the entire market implied volatility surface within a couple of basis points is impressive.
Weather derivatives may finally be fulfilling their potential in an energy context, in a way that has been promised for twenty years or more. In "Applications of weather derivatives in the energy market", Kaijie Cui and Anatoliy Swishchuk survey various types of weather-related risks in different industries. They discuss the differences between weather derivatives and insurance and the advantages of using weather derivatives instead of insurance in risk management. For the temperature futures, they first provide a simple static hedging example and then, through a system of models for energy and temperature, propose a dynamic hedging formulation.
In our final paper, "Crude oil price volatility spillovers into major equity markets" by Bahram Adrangi, Arjun Chatrath, Joseph Macri and Kambiz Raffiee, the authors observe that the price and index series exhibit nonlinear dependencies with bidirectional volatility spillovers. Finding evidence of asymmetric market responses to negative and positive shocks, they estimate asymmetric bivariate VAR-EGARCH models. They find shock transmissions to be asymmetric in the sense that positive and negative shocks of the same size on oil prices have unequal impact on the volatility of equities. Specifically, volatility responses and spillovers are more severe following negative news shocks in each market. Considering the adverse income and wealth effects of negative shocks to oil prices on the economies under study, the findings are in contrast to the notion that some economies are better able to weather these kinds of shocks. Furthermore, it is clear that maintaining adequate strategic crude oil reserves in the United States and in other major economies has been paramount in coping with supply and price volatility.
Overall, these papers continue to place The Journal of Energy Markets at the forefront of practical research on key themes at the intersection of energy markets and finance. We expect all four to become well-cited references.
Derek W. Bunn
London Business School