Commodities and Commodities Derivatives, Computational Methods for Derivatives

EMEC054S7 (30 credits)
Full-time and Part-time Year 2
Autumn and Spring Term

Lecturers: Hélyette Geman and Rita D’Ecclesia

Course Aims and Objectives

This 60 hour course provides a thorough analysis of commodity markets, their specificities and how they differ from bond and stock markets. The students will become familiar with the Exchanges, the instruments and the hedging and trading strategies. The different sub-classes of commodities are analysed and discussed: metals, agriculturals, shipping. The energy class (crude oil, coal and natural gas, electricity) will be analysed in detail. The course provides a thorough overview of recent developments in energy and commodities modelling, along with the necessary computational methods. Students will be equipped with a critical understanding of current scientific research output. Particular attention will be brought to the economic fundamentals, including inventory, reserves and forward curve.

At the end of this course, students will be able to demonstrate that they can:

• understand the specificities of commodities as a new asset class;
• recognise the unique features of electricity markets (natural gas, hydro, nuclear and emissions);
• understand mathematical and statistical techniques;
• understand some of the important financial concepts underlying the theory of energy instruments as well as other commodities;
• apply econometric models to commodity spot and forward prices in order, in particular, to build a consistent model for a multi-commodity;
• use trees and Monte-Carlo methods for the pricing of volumetric options (financial or real) that are specific to commodities markets.

Outline of Topics

The first paper of the course will be dedicated to the presentation of

• commodity spot markets
• major Exchanges
• liquid indexes
• most traded instruments

The theory of storage will relate inventory to the shape of the forward curve and spot price volatility.

The second part of the course will present

• the oil and refined products market
• Natural gas and LNG
• the coal market
• the shipping market and freight indices

The third part of the course will describe commodity risk management using forwards/Futures and options as well the unique challenges posed by the existence of spikes and structural breaks in price trajectories. Seasonality, both in a deterministic and stochastic form, will be discussed in the context of agricultural and energy commodities.

Value at Risk and stress testing will be presented for commodity portfolios.

The fourth part of the course will be devoted to

• spot price modelling
• forward curve modelling (including through a PCA approach)
• option pricing models for commodity markets: Black, Margrabe, spread options
• inclusion of stochastic volatility
• gas storage and physical assets valuation

The last part will cover the unique features of electricity markets, the role of supply and demand in price formation and construction of the power stack function. Emissions and carbon markets will be presented and discussed.

Course Assessment

Coursework counts for 20% and the June exam for 80%.

Recommended Reading

• H. Geman (2008) Risk Management in Commodity Markets: From Shipping to Agriculturals and Metals, Wiley Finance.
• H. Geman (2005) Commodities and Commodity Derivatives: Agriculturals, Metals and Energy, Wiley Finance.
• Eydeland (2003) Energy and Power Risk Management, Wiley Finance.
• Harris (2006) Electricity Markets, Wiley Finance.