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VaR Energy
VaR Energy
VaR Energy
Val u e
at
Ris k:
Variations
on a theme
alue at Risk (VaR) is Since then, some trading during a given period of time
Cumulative probabilities, %
1.2 simulation
sures that accommodate the entire results
empirical distribution of returns. This 1.0
is a problem, because it is extreme
0.8
events—like a large market move—that VaR based on extreme
VaR based
value distribution
produce the largest losses. 0.6 on normal
distribution
Using stress tests and scenario analy-
0.4
ses to simulate the changes in the value
of a portfolio under hypothetically 0.2
extreme market conditions is no solu-
0.0
tion, because they cannot explore all –35 –30 –25 –20 –15 –10 –5 0
possible scenarios. What’s more, such Loss, %
analyses do not indicate how likely it is
that extreme events will occur. companies has been limited to a pas- is more complicated—and interest-
The problems resulting from extreme sive role—for reporting rather than ing—than risk management in most
events are not unique to risk manage- prescriptive purposes. Now, howev- other fields because electricity and gas
ment; they also arise in disciplines such er, firms in dynamic industries— production and trading are physical
as hydrology and structural engineer- such as energy—are beginning to use processes.
ing, where extreme events can have it for more proactive purposes—for As energy markets become more
devastating consequences. Researchers risk management rather than just risk complex, energy firms are embracing
and practitioners in these fields handle measurement. Active VaR can iden- risk management systems and proce-
the problem by using extreme value tify business activities that incur too dures, such as Value at Risk, to become
theory (EVT). EVT is a specialist much risk relative to their level of more competitive. ■
branch of statistics that derives general return. It can also point out which
properties of the tail, or extreme end, of assets, business processes, and activ-
Dr. Carlos Blanco is manager of global
a distribution by making the best possi- ities are increasing or decreasing the support and educational services at
ble use of a limited set of its realized corporation’s overall risk exposure. Financial Engineering Associates,
extreme values. By focusing on the Most risk professionals agree that (www.fea.com) Berkeley, Calif.
extreme tail of a distribution, VaR can risk management in the energy industry
be estimated with a confidence of
greater than 95%.
The difference EVT makes to VaR
estimates is illustrated in Figure 3,
which shows the tail of the West Texas
Intermediate (WTI) daily return distrib-
Profit at Risk:
ution from 1983 to 1999. The dots indi-
cate the actual extreme return observa-
tions, the continuous line by the right
More realistic than
vertical axis represents the tail (assum-
ing that logarithmic returns follow a
normal distribution), and the other con-
Value at Risk
tinuous line represents the tail of an
extreme value distribution fitted to ompanies that generate or Volume risk
these data. The message this figure con-
veys is that the confidence level of
EVT-calculated VaRs is much higher
than that of VaRs calculated using tradi-
tional methodologies.
C deliver electricity, or sell
load-following ancillary ser- The financial risks estimated by typ-
vices or retail load services, ical VaR calculations are wholly relat-
need a more accurate and
robust risk-measurement met- B Y C HAL
ed to market price movements.
However, the real and increas-
B ARNWELL
ric than the “pure” form of ingly complex energy industry
Toward risk management Value at Risk (VaR). Profit at Risk engenders additional financial risks
(PaRTM) is a more useful measure for a that VaR cannot measure. The most
Traditionally, the use of VaR within variety of reasons. important of these is volume risk,
Global Energy Business, May/June 2001 15