Valuation and Risk Management of Physical Assets

Steve Leppard

Asset-backed trading is a style of commodity trading that takes advantage of the parallels between physical assets and commodity market positions. In asset-backed trading, physical plant is used to exploit the volatility of the traded markets through its ability to make flexible physical delivery. Such flexibility resembles the optionality offered by instruments in traded financial and commodity markets, and so we naturally look to these markets for appropriate techniques to value these assets.

Quantitative practitioners seeking a fair market valuation for physical assets use techniques derived from the worlds of derivative pricing and optimisation theory, and sometimes use the term “real-option valuation” to describe their activity. Care needs to be taken when applying these techniques to assets that may be subject to unhedgeable risks. This chapter surveys some of the issues encountered by risk managers, quantitative analysts, traders and originators when carrying out, managing and interpreting such valuations.

The broad-based material in this chapter starts by examining the types of risk encountered in asset-backed trading, then proceeds to look at some aspects of market

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