Mark-to-Futures Forward Curve Methodology

The introduction of AASB 139 has significant implications for NEM participants, which are using hedging instruments. This regulation now stipulates that all hedging instruments must be Marked-to-Market on a monthly basis.

Electricity Market Participants, such as electricity retailers, routinely hedge their exposure to pool price with either OTC or exchange-traded electricity derivatives. Unlike commodity, foreign exchange and interest rate derivatives, pricing and hedging of electricity derivatives present unique problems due to both the relative infancy of the industry and the inherent complexity of the electricity market. These difficulties are exacerbated by insufficient (averaged quotes only!) or unreliable OTC-transaction data as well as inadequacy of existing forecasting methods for both spot price and demand. Simplistic forecasting methodologies purely based on historical spot price data only might lead to dangerous underestimation of risks as they cannot react immediately to changes in regulatory environment, abrupt market decision to increase spot prices or expenditures triggered by environmental concerns.

From this prospective, our Mark-to-Futures Forward Curve (MtFFC) represents well-founded and simple to use tool for both-hedging and risk management for portfolios of electricity derivatives. MtFFC incorporates all the necessary features of the spot market such as seasonality, peak-offpeak relationship and observable abrupt price changes. Unlike OTC products, futures are credit-free and market traded, so all prices are completely disentangled from the transaction counterparties. Exponential growth in futures trading volumes provides additional reliability to MtFFC-underpinned forecasting.

Methodology for building of MtFFC involves three sequential major stages:

1. Building of Forward Demand Curve (FDC) by employing relative periodicity of historical demand data. The algorithm accounts for season, day and tick type therefore producing FDC with all the desired features. Our FDC has passed rigorous statistical backtesting on historical demand data.
2. FDC is used as a primary driver for construction of Forward Spot Price Curve (FSPC). It is “threaded” through sophisticated grouping mechanism with dynamically adjusted sample size, which ensures statistically-reliable number of historical spot price data points for every tick. Resulting FSPC combines FDC periodicity with price spikes reflecting extreme but repeating market conditions happened in the past (and awaited in future). Once again, FSPC has been extensively backtested and calibrated on historical price data.
3. The derivation of MtFFC is based on two main principles:
   1. Physical nature of the NEM will remain intact in the foreseeable future, i.e. seasonal, peak-offpeak dependencies as well as inevitable plant outages or system failures causing drastic price fluctuations will continue to exist. Therefore MtFC should inherit all this features from FSPC; and
   2. Market traders add their premium margin to the current spot prices in anticipation of changes in market environment. Therefore some ‘premium function’ should ‘top-up’ FSPC so, after corresponding re-averaging the resulting MtFFC will yield quoted contract prices.

In case of MtFFC the ’sanity check’ is straightforward. For construction of MtFFC d-cyphaTrade’s quarterly futures quotes have been used. After re-averaging, abovementioned quarterly contract prices yield yearly and half-yearly contract quotes. Obviously MtFFC satisfies every re-averaging test.

Historical analysis suggests that it is sufficient to recalculate FSPC with a monthly frequency. On the contrary, MtFFC which reflects the volatility of the Forward Market would be recalculated on the basis of daily settlement results.

Please contact us for more information.