Chapter 2: risks, markets and contracts Flashcards
Concept of risk
1) Future is uncertain
2) uncertainty translates into risk: in this case, risk of loss of income 3) risk equals probability X consequences
4) doing business means excepting some risks 5) willingness to accept risk that varies: venture capitalists versus retiree
6) ability to control risk varies: professional traders versus novice investors
Sources of risk
1) Technical risk
2) external risk
3) price risk
Technical risk
Failure to produce or deliver because of technical problem: power plant outage, congestion in the transmission system
External risk
Failed to produce or deliver because of cataclysmic event: Weather, earthquake, war
Price risk
- Having to buy at a price much higher than expected
- having to sell at a price much lower than expected
Managing risks: excessive risk hampers economic activity
- Not everybody can survive short-term losses
- Society benefits of more people can take part
- Business should not be limited to large companies with deep pockets
How can risk be managed
- Reduce the risk
- Share the risk
- Relocate the risk
Reducing the risks
- Reduce frequency or consequences of technical problems
- Reduce consequence of natural catastrophes
- Security margin in power system operation
Reduce frequency or consequences of technical problems
Those who can reduce risk should have an incentive to do it: owners of power plants
Reduce consequences of natural catastrophes
- Owners and operators of transmission system
- design systems to be able to withstand rare events : enough crews to repair the power system after a hurricane
Security margin in power system operation
- Limits the consequences of rare but unpredictable and catastrophic events
- increases the daily cost of electrical energy
- does not cover all possible problems because that would cost too much
Sharing the risks
- Insurance
- Grid operator does not have to pay compensation in the event of a blackout
Showing the risks: insurance
- All the members of large group pay a small amount to compensate the few who suffer a big loss
- the consequences of a catastrophic event are shared by a large group rather than a few
Relocating risk
- Possible if one party is more willing or able to accept it: loss is not catastrophic for this party, this party can offset this loss against gains in other activities
- applies most to price risk
- how does this relate to markets?
Characteristics of markets
- The time of delivery of the goods
- the mode of settlement
- any conditions that might be attached to this transaction
Spot market
Immediate market, on the spot: -agreement on price – agreement on quantity – agreement on location -unconditional delivery -immediate delivery
Examples of spot markets
Can be formal or informal:
- food market
- basic shopping
- Rotterdam spot market for oil
- commodities markets: corn, wheat, cocoa, coffee
Sports markets: advantages
– Simple
-flexible
– immediate
Spot markets: disadvantages
-Prices can fluctuate widely based on circumstances
– example: effect of frost in Brazil on the price of coffee beans, effect of trouble in the middle east on the price of oil
Spot market risks
- Market may not have much depth
- lack of depth causes large price fluctuations
- relying on the spot market for buying or selling large quantities is a bad idea
Spot market may not have much depth
- Not enough sellers: market is short
- not enough buyers: market is long
Spot market: lack of depth causes large price fluctuations
-Smaller producer may have to sell at a low price
-small purchaser may have to buy at a high price
– price risk
Forward contract
– Agreement: quantity and quality, price, date of delivery (not immediate)
- Paid at time of delivery
- unconditional delivery
How is the forward price set?
-Both parties look at the alternative: spot price
– both forecast what the spot price is likely to be
Forward contracts: sharing risk
-In a forward contract, the buyer and the seller share the risk that the price differs from the expectation
– difference between contract price and spot price at time of delivery represents a profit for one party and a loss for the other
-however, in the meantime they have been able to get on with the business: buy new farm machinery, sell the flour to bakeries
Attitude towards risk: expires less risk averse than seller
- Buyer can negotiate a forward price lower than the expected spot price
- seller agrees to this lower price because it reduces its risk
- difference between expected spot price and forward price is called a premium
- premium equals price that seller is willing to pay to reduce risk
Attitudes towards risk: if by a small risk averse than seller
- Seller can negotiate a forward price higher than the expected spot price
- buyer agrees to this higher price because it reduces its risk
- buyer is willing to pay the premium to reduce risk
Diversification
- Diversification: deal with more than one commodity
- Average risk of different commodities
- farmers may not want to diversify the production because it could be inefficient
Physical participants
-Produce, consume or can store the commodity
– face undiversified risk because they deal in only one commodity
Traders a.k.a. speculators
- Cannot take physical delivery of the commodity
- diversify the risk by dealing in many commodities
- specialise in risk management
Trading by speculators
- Cannot take physical delivery of the commodity
- must balance their position and date of delivery: quantity bought must equal quantity sold, buy or sell from spot market if necessary
- may involve many transactions
- forward contracts limited to parties who can take physical delivery
- need a standardised contract to reduce the cost of trading: future contract
- future contracts (futures) allow others to participate in the market and share the risk
Importance of information: speculators
-Speculators own some of the commodity before it is delivered
-they carry the risk of a price change during that period
-need deep pockets
– without additional information, this is gambling
-information helps speculators make money
-example: global perspective on the harvest for wheat, long-term weather forecast and it’s effect on the demand for gas and electricity
Options
- Spot, forwards and future contracts: unconditional delivery
- options: conditional delivery:call option, put option
- two elements of the price
Call option
Right to buy at a certain price at a certain time
Put option
Right to sell at a certain price at a certain time
Two elements of the price
- Exercise or strike price equals prize paid one option is exercised
- premium or option fee equals price paid for the option itself
Two-way contract for difference
Combination of a call and put option for the same price➡️ will always be used
