Derivatives Hedging Swaps

Weather derivative hedging
& Swap illiquidity

www.weatherderivs.com 2
Call/Put Hedging
Diversification or Static hedging
(portfolio oriented)
PCA
Markowitz
SD
Dynamic hedging (Index hedging)
Dynamic Hedging
1. Temperature Simulation process used

2. Swap hedging and cap effects

3. Greeks neutral hedging
1. Temperature Simulation process used
Temperature simulation
GARCH
ARFIMA
FBM

ARFIMA-FIGARCH
Bootstrapp
Long Memory
Homoskedasticity
Short Memory
Heteroskedasticity
Heteroskedasticity
& Long Memory
Part 1 Temperature Simulation process used
ARFIMA-FIGARCH model
i i i i i
y m S T o + + =
Seasonality
Trend ARFIMA-FIGARCH
Seasonal volatility
ARFIMA-FIGARCH definition
( )( ) ( ) ( )
t t
d
L y L L c u | =
0
1
Where, as in the ARMA model, is the unconditional mean
of y
t
while the autoregressive operator
and the moving average operator
are polynomials of order a and m, respectively, in the lag
operator L, and the innovationsc
t
are white noises with the
variance
2
.
( )

=
=
a
j
j
j
L L
1
1 | |
We consider first the ARFIMA process:
( )

=
+ =
m
j
j
j
L L
1
1 u u
FIGARCH noise
( )
1
O =
t t t
Var h c
Given the conditional variance

We suppose that
( ) | | ( ) ( )( )
2 2
1 ] 1 [ 1
t
d
t t
L L L h L c c | e | + =
Cf Baillie, Bollerslev and Mikkelsen 96 or Chung 03 for full specification
Long term memory
Distributions of London winter HDD
Histo
Sim
Densities
2,400 2,200 2,000 1,800 1,600 1,400 1,200 1,000
0.003
0.003
0.003
0.002
0.002
0.002
0.002
0.002
0.001
0.001
0.001
0.001
0.001
0.000
0.000
0
Histo Sim
Average 1700.79 1704.54
St Dev 128.52 119.26
Skewness 0.42 -0.01
Kurtosis 3.63 3.13
Minimum 1474.39 1375.13
Maximum 2118.64 2118.92
With similar detrending methods

The slight differences come mainly
from the year 1963
2. Swap hedging and cap effects
Swap Hedging
Long HDD Call and oopt
call
HDD Swap
Long HDD Put and oopt
put
HDD Swap
Dynamic values
Part 2 Swap hedging and cap effects
Deltas of a capped call
Delta of Capped Calls
cap 200
gfedcb
cap 400
gfedcb
cap 800
gfedcb
Mean
2 100
2 000
1 900
1 800
1 700
1 600
1 500
1 400
1 300
Delta
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
Vol
140
130
120
110
100
90
Deltas of capped swaps
Delta of Capped Swaps
Delta Swap cap 200
gfedcb
Delta of Swap cap 400
gfedcb
Delta of Swap cap 800
gfedcb
Strike
2 000
1 900
1 800
1 700
1 600
1 500
1 400
1 300
Delta
1
0.8
0.6
0.4
0.2
Vol
140
130
120
110
100
90
Call optimal delta hedge
oopt
call
= o
call
/ o
swap
Delta of Capped Call & Swap
call cap 200
gfedcb
swap cap 200
gfedcb
Mean
2 100 2 000 1 900 1 800 1 700 1 600 1 500 1 400 1 300
Delta
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
NOT = 1
Prices of Capped Call & Swap
swap cap 200
gfedcb
call cap 200
gfedcb
Mean
2 100 2 000 1 900 1 800 1 700 1 600 1 500 1 400 1 300
F
a
i
r

V
a
l
u
e
s
150
100
50
0
-50
-100
-150
Put optimal delta hedge
oopt
put
= o
put
/ o
swap
NOT = 1
Delta of Capped Put & Swap
swap cap 200
gfedcb
put cap 200
gfedcb
Mean
2 100 2 000 1 900 1 800 1 700 1 600 1 500 1 400 1 300
Delta
0.8
0.6
0.4
0.2
0
-0.2
-0.4
-0.6
Prices of Capped Put & Swap
swap cap 200
gfedcb
put cap 200
gfedcb
Mean
2 100 2 000 1 900 1 800 1 700 1 600 1 500 1 400 1 300
F
a
i
r

V
a
l
u
e
s
150
100
50
0
-50
-100
-150

3. Greeks neutral hedging
Traded swap levels
THE DATA USED IS MOST CERTAINLY
INCOMPLETE

We would like to thank Spectron Group plc
for providing the weather market swap data
Part 3 Greeks Neutral Hedging
Historical swap levels LONDON HDD December
London HDD December
350
360
370
380
390
400
410
05-Nov-02 10-Nov-02 15-Nov-02 20-Nov-02 25-Nov-02 30-Nov-02 05-Dec-02 10-Dec-02 15-Dec-02
Date
H
D
D
Mean
Max
Min
Current Index
Weather Index Cone - LONDON HDD December 2002
28/12/2002 21/12/2002 14/12/2002 07/12/2002
500
480
460
440
420
400
380
360
340
320
300
280
260
240
220
200
180
160
140
120
100
80
60
40
20
Forward ~ 380
Before the period started: swap level below
Then swap level above like the partial index
Historical swap levels LONDON HDD January
London HDD January
250
300
350
400
450
500
30-Dec-02 04-Jan-03 09-Jan-03 14-Jan-03 19-Jan-03 24-Jan-03
Date
H
D
D
Mean
Max
Min
Current Index
Weather Index Cone - LONDON HDD January 2003
31 29 27 25 23 21 19 17 15 13 11 09 07 05 03 01
580
560
540
520
500
480
460
440
420
400
380
360
340
320
300
280
260
240
220
200
180
160
140
120
100
80
60
40
20
Forward ~ 400
Before the period started: swap level below
Then swap level has 2 peaks and does not follow
the partial index evolution which is well above the
mean
Part 3 Delta Vega Neutral Hedging
Historical swap levels LONDON HDD February
Mean
Max
Min
Current Index
Weather Index Cone - LONDON HDD February 2003
28 26 24 22 20 18 16 14 12 10 08 06 04 02
500
480
460
440
420
400
380
360
340
320
300
280
260
240
220
200
180
160
140
120
100
80
60
40
20
London HDD February
250
270
290
310
330
350
370
390
04-Jan-
03
09-Jan-
03
14-Jan-
03
19-Jan-
03
24-Jan-
03
29-Jan-
03
03-Feb-
03
08-Feb-
03
13-Feb-
03
18-Feb-
03
23-Feb-
03
Date
H
D
D
Forward ~ 350
Before the start of the period,
the swap level is well below the forward
Then swap level converges toward with forward
Historical swap levels LONDON HDD March
Mean
Max
Min
Current Index
Weather Index Cone - LONDON HDD March 2003
30 28 26 24 22 20 18 16 14 12 10 08 06 04 02
440
420
400
380
360
340
320
300
280
260
240
220
200
180
160
140
120
100
80
60
40
20
London HDD March
282
284
286
288
290
292
294
296
298
300
302
30-Dec-
02
09-Jan-
03
19-Jan-
03
29-Jan-
03
08-Feb-
03
18-Feb-
03
28-Feb-
03
10-Mar-
03
20-Mar-
03
30-Mar-
03
Date
H
D
D
Forward ~ 340
Before the period started: swap level below the forward
Then swap level converges toward final swap level
Swap level Behaviour
OF COURSE IT DEPENDS ON THE
MODEL USED TO ESTIMATE THE
FORWARD REFERENCE
The swap seems to start to trade below its
forward before the start of the period and
remains quite constant prior the start of the
period (or 10 days before)
The swap level converges quickly to its
final value (10 days in advance)
There can be very erratic levels

Consequences on Option Hedging
Before the start of the period when the swap level is below the forward (if it
really is!) then the swap has a strong theta, a non zero gamma (if capped) and a
delta away from 1 (if capped)
The delta of the traded swap convergences towards 1 slowly
10 days before the end of the period, the delta is close to 1, the theta is close to
zero, the gamma is close to zero
The vega of the option will be close to zero 10 days before the end of the period
Erratic swap levels must not be taken into account
Before the start of the period, assuming the swap level is quite constant, it is
easier to sell the option volatility than during the period
During the period, the theta of the option will not offset the theta of the swap,
nor will the gamma of the option offset the gamma of the swap

No neutral hedging
Due to the cap on the swap and swap illiquidity the
resulting position is likely to be non Delta neutral,
non Gamma neutral, non Theta neutral and non
Vega neutral
If the swaps are kept (impossible to roll the swaps),
the Gamma and Theta issues are likely to grow
Solutions:
Minimise function of Greeks
Minimise function of payoffs (e.g. SD)
Market Assumptions
Bid/Ask spread of Swap is 1% of standard deviation
(London Nov-Mar Stdev 100 => spread = 1 HDD).
No market bias: (Bid + Ask) / 2 = Model Forward
Option Bid/Ask spread is 20 % of StDev.

Trajectory example
Forward trajectory - London HDD December 02
330
340
350
360
370
380
390
400
410
2
5
/
1
1
/
2
0
0
2
3
0
/
1
1
/
2
0
0
2
0
5
/
1
2
/
2
0
0
2
1
0
/
1
2
/
2
0
0
2
1
5
/
1
2
/
2
0
0
2
2
0
/
1
2
/
2
0
0
2
2
5
/
1
2
/
2
0
0
2
3
0
/
1
2
/
2
0
0
2
0
4
/
0
1
/
2
0
0
3
date
H
D
D
0
10
20
30
40
50
60
S
t
D
e
v
1 2 3 4
1: decrease in vol
(15%) implies a
higher gamma and
theta => rehedge

2: increase in vol =>
less sensitive to
gamma and theta
but forward down by
25% of vol =>
rehedge

3: forward down, vol
still high and will go
down quickly (near
the end of the
period) => rehedge

4: sharp decrease in
vol and forward =>
rehedge
Simulation results summary
The smaller the caps on the swap the higher the frequency of adjustment
must be and the higher is the hedging cost (transaction/market/back
office cost). Alternately we can keep the swap to hedge extreme
unidirectional events.
For out of the money options, if the caps of the option are identical to the
caps of the swap, then the hedging adjustment frequency is reduced
(delta, gamma are close).
The combination of swap illiquidity with caps creates a substantial bias
in Greeks Hedging. The higher the caps the more efficient is the hedge.
Optimising a portfolio using SD, Markowitz or PCA criterias is still a
favoured solution for hedging but is inappropriate for option volatility
traders.
Conclusion
With the success of CME contracts, other
exchanges and new players may enter into the
weather market.
This may increase liquidity which will make
dynamic hedging of portfolios more practical.
New speculators such as volatility traders may
be attracted. This may give the opportunity to
offer more complex hedging tools that the
primary market needs with lower risk premia.
References
J.C. Augros, M. Moreno, Book Les drivs financiers et dassurance, Ed
Economica, 2002.
R. Baillie, T. Bollerslev, H.O. Mikkelsen, Fractionally integrated generalized
autoregressive condition heteroskedasticity, Journal of Econometrics, 1996, vol
74, pp 3-30.
F.J. Breidt, N. Crato, P. de Lima, The detection and estimation of long memory in
stochastic volatility, Journal of econometrics, 1998, vol 83, pp325-348
D.C. Brody, J. Syroka, M. Zervos, Dynamical pricing of weather derivatives,
Quantitative Finance volume 2 (2002) pp 189-198, Institute of physics publishing
R. Caballero, Stochastic modelling of daily temperature time series for use in
weather derivative pricing, Department of the Geophysical Sciences, University
of Chicago, 2003.
Ching-Fan Chung, Estimating the FIGARCH Model, Institute of Economics,
Academia Sinica, 2003.
M. Moreno, "Riding the Temp", published in FOW - special supplement for
Weather Derivatives
M. Moreno, O. Roustant, Temperature simulation process, Book La
Rassurance, Ed Economica, Marsh 2003.
Spectron Ltd for swap levels

Derivatives Hedging Swaps

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Derivatives Hedging Swaps

Uploaded by

Copyright:

Available Formats

Weather derivative hedging

& Swap illiquidity

You might also like