September 2011

Support Analytics For

Asset-Based Trading
Financial Engineering tools for asset-backed trading and hedging strategies.
By Carlos Blanco & Michael Pearce
79
HERE, WE DISCUSS the role of risk and trading
analytics to support asset-based optimization
and trading strategies building upon our prior
contributions which showed how dynamic risk
simulation tools can be applied to complex decision
problems involving multiple sources of risk and
state variables as well as calculate risk, value and
performance metrics.
1
Optimization of Physical Assets
& Trading Strategies
Traditionally, physical assets
such as storage facilities, pipelines,
transmission networks, refineries,
and power plants were operated by
engineers rather than trading groups,
resulting in sub-optimal performance
from a profit maximization perspective.
Many energy and commodity firms
have established asset-backed trading
groups whose objective is to enhance
the risk adjusted profitability of its
physical assets based on observable
market spreads, their potential
variability, as well as the specific asset
operating constraints.
It is critical for asset-based trading
groups to articulate and communicate
the value and risk of those strategies
with asset operators as well as senior
management.
For different reasons, poor communication and
lack of understanding between engineers that
operate and maintain the assets and the financial
engineers in charge of modelling the performance
of those assets is the norm rather than the exception.
For example, the first generation models used
by risk groups and traders were too simplistic
and did not accurately capture the market and
asset dynamics and constraints, leading to poor
or unrealistic decisions from an operational
perspective. Figure 1 shows the key building blocks
for the design of decision support analytics for
asset-based strategies.
The valuation, risk metrics and hedging ratios
calculated from model that do not fit the criteria
outlined above are not just likely to be inaccurate,
but also likely to lead to sub-optimal decisions that
would impact the asset-base strategys profitability.
Fortunately, one of the more relevant developments
in recent years in financial engineering applied
to energy risk modelling is the pricing, modelling
and hedging of physical assets and asset-based
strategies for power and gas portfolios.
Risk Management For
Asset-Based Trading Strategies
Risk management for asset-based trading
strategies involves identifying and quantifying
multiple risk dimensions. To capture those risk
dimensions, a dynamic simulation framework
with three critical components is needed: Ability
to handle multiple risk factors (e.g. commodities,
credit events, operational issues), multiple
instruments (e.g. physical contracts, derivatives), as
well as the ability to capture events taking place at
multiple steps in time.
Many energy and commodity
firms have established asset-
backed trading groups
Figure 1: Building Blocks of Asset-Backed
Trading Support Analytics
Source: www.nquantx.com
Realistic Multi-Step Spot, Forward Curve
& Spread Scenario
Asset & Trading Constraints Explicitly
Captured & Modelled
Integration Of Market Liquidity,
Hedging & Transaction Costs
Backtesting Performance Of Asset-Based
Trading Strategy
Dynamic risk simulation involves modelling the
variability of one or more metrics (e.g., cash flow,
earnings, mark-to-market, liquidity, etc.) based on
realistic potential changes
in a set of key state variables,
as well as the firms response
to those changes (e.g.,
operating, hedging and trading strategies). The
analysis consists on leaping forward at various
points in time into the future.
New technologies exist which streamline the
storage and consistent definition of data across
the enterprise, and risk management
systems should take full advantage of them
to achieve consistency of risk information
across different business units. For example,
contract, market and counterparty
information that often resides in different
systems used by market and credit risk
groups needs to be integrated in order to
perform Earnings at Risk (EaR) and Cash
Flow at Risk (CFaR) analysis (Figure 2).
Another problem is that the risk
management groups in many firms are
still organized in silos, and often focused
on measuring individual risks, or risks for
a component of the portfolio. For example
the financial portfolio to hedge or monetize
the value of the asset is just a component of
the profitability of the asset, and analysing
it in isolation is not sufficient.
Spreadsheets vs CTRM Systems:
Combining the best of both worlds
Decision-support tools for asset-based
trading strategies need to strike a balance
between flexibility and integration into
existing systems. Those tools need to
be capable of taking multiple inputs
coming from different systems, and
also perform a large number of
computations in simulation-based
environments.
The first column in Table 1 illustrates
the main problems with the current
set up of decision support analytics
at many firms, which includes a mix
of individual spreadsheets design
to solve specific issues, stand-alone
solutions developed by quantitative
teams that are not fully integrated or
vetted (e.g. Matlab-based solutions)
and tasks performed by larger
systems. The second column suggests
solutions to each of those problems.
On one side, E/CTRM systems
are usually designed to excel
at performing other tasks such as scheduling,
nomination or accounting for physical trades.
However, their limited offering in terms of trade-
support analytics and asset optimization have the
limitation of being non-intuitive and inflexible to
perform customized analysis.
A flexible environment such as the one provided
by spreadsheets as well as programming languages
September 2011 80
New technologies exist which streamline the storage
and consistent definition of data across the enterprise
ASSET BACKED TRADING
Performance Measurement For
Asset-Based Strategies
One of the areas where firms can reap tangible
benefits from deploying risk analytics for asset-
based strategies is in the process of setting up
performance benchmarks.
If a trading group relies on the firms assets to
meet their profit targets, but traders are not charged
an explicit premium based on the optionality
embedded on those assets, they are clearly operating
at an advantage over other units. As a result, their
raw performance is often stellar, but there may be
reasons besides the skill or luck of the traders.
Setting up the baseline profitability based on
mechanical low risk trading strategies can level the
playing field, and also assist in determining which
traders are truly adding value.
For example, storage assets can be dynamically
hedged by optimizing the intrinsic value of the asset
over time. That intrinsic value could be the baseline
profit to measure the contribution of the traders,
not the actual performance.
Figure 2: Application of Decision-Support Analytics
For Asset-Backed Trading Strategies
Source: www.nquantx.com
Valuation Hedging
Market
Risk
Budget
Risk
Cash Flow
Risk
Credit
Exposure
Operational
Risk
Volumetric
Risk
Performance
Measurement
September 2011
ASSET BACKED TRADING
81
for statistical and mathematical computing (such
as R and Matlab) can enable analysts and traders to
monitor the impact of alternative hedging strategies
or perform sensitivity analysis to change in market
conditions or evaluate operational events.
Stand-alone spreadsheets play a critical role and
can provide quick answers not available through
other systems, but their use also introduce other
issues that need to be evaluated. For example,
traders and analyst still spend a significant
amount of their time maintaining and updating
those spreadsheets. That process is highly prone to
human error, and therefore introduces significant
model risk for their firms.
In addition, the more sophisticated spreadsheets
are not easily audited and often fall outside
the control of the risk, IT and audit groups. For
example, if a trader moves to a competitor, poorly
documented and tested spreadsheets are likely to
be abandoned, which results in a loss of know-how
for the firm.
Instead of relying on inflexible CTRM systems or
stand-alone spreadsheets, a better solution would
be one that would allow traders and risk managers
to continue using spreadsheets as their front-
end tool, but with integrated data tools as well as
analytic support engines running underneath and
performing the intensive computation tasks. The
right modular framework design would also increase
the communication with other legacy systems.
A flexible analytic engine for asset-based
strategies should allow for the segregation of
analytic processes to enable modular design and
increased scalability. For instance, the separation
of instrument-level valuation analytics from the
market scenario generation engine increases the
ease of editing or adding new valuation or Monte
Carlo routines in the future.

The right modular framework design

would also increase the communication
with other legacy systems systems
Table 1: State of Asset-Based Trading Support Analytics
Asset-Based Trading Support Analytics
(ETRM + Spreadsheets)
NQuantX Asset-based Trading Solutions
(Integrated analytics with Excel interface)
Multiple spreadsheets individually developed and
maintained
Excel interface to
risk libraries
High model risk
Tested and supported code and applications.
Source control
Manual workflow/ intensive Automated Workflow
Disconnected and/or unsupported trading
analytics function
Dedicated analytics group committed to
continuous enhancements
Reliance on individual expertise.
Personnel risk
Best of breed. Access to financial engineering
support group
Source: NQuantX, LLC
Carlos Blanco is Co-Founder and Managing
Director of NQuantX, LLC, a nancial engineering
rm that develops customized software to
design and implement hedging programs and
trading strategies, as well as valuation and risk
measurement of energy derivatives, long term
contracts and physical assets. He also conducts
several courses on energy derivatives hedging,
pricing and risk management, as well as credit
and counterparty risk management for the
Oxford-Princeton Program. He is a lecturer on
risk management at the University of California,
Berkeley.
E: carlos@nquantx.com
Michael Pierce is Co-Founder and Director of
Financial Engineering at NQuantX LLC. Some
specic areas of development include energy
forward curve calibration and modelling,
development of a hybrid electricity model used
in Monte Carlo real asset valuation of generating
assets and load serving agreements, correlation
matrix calibration and multi-regional temperature
modelling for weather derivatives
www. nquantx.com
NQuantX Global Commodity Workbench was
designed to meet needs of firms with asset-based
strategies such as valuation, hedging and risk
quantification by offering software solutions and
advisory services. The end result is that traders
can continue working with spreadsheets, but in
a controlled environment and where it is easier
and faster to deploy new solutions.
Footnotes
1. See www.commodities-now.com for more information.