I'm a bit late in commenting on the forum on Commodities, energy markets and emissions trading that took place at Fields last week. Like the Operational Risk forum last month, this was another great learning opportunity for a outsider like myself. So in the same spirit of my blog post on that forum, here is a summary of what I learned from this one:
- commodity markets are fertile ground for exotic derivatives, because physical constraints (say the rate at which you can pump oil in and out of a tanker) influence the design and valuation of even the most basic contracts;
- most things (contracts, hedging strategies, etc) depend on spreads, consequently correlations (between dates, locations, type of fuel, etc) play an essential role. It becomes important to know when one can "Margrabe the world away";
- different players in the market (say producers and retailers) have different likes and dislikes (say towards spikes in prices and their persistence), so the story behind the change of measure from physical to risk-neutral probabilities is an elaborate one (for example, both the long-term level and the speed of mean reversion might change from one measure to another);
- enforcing consistency constraints while modeling and fitting implied volatility curves and surfaces across time is as difficult a problem for commodities as it is for interest rates, and perhaps might benefit from common techniques;
- there exist reasonably advanced models for carbon emission markets and they perform relatively well when compared to actual data for the first phase of the EU-ETS market, whereas a lot needs to be done to model newer features in these markets (multi-periods, banking of allowances, CERs, etc)
- electricity markets are very developed and well understood both in theory and practice. As a consequences, linking them to carbon emission markets in a unified way might shed some light.
The forum concluded with an extremely lively panel (sadly not available in audio recording). I tried my best to stir the discussion towards the benefits and flaws of carbon emission markets, but what really caught the attention of most panelists and people in the audience was the relation between academia and industry. The highlight for me was Nicole El Karoui standing up at the back of the room and delivering a passionate defense (in French) of the role of independence of academic research. She said that although she learned important lessons from the markets (for example the importance of model robustness, something that academics seldom think about), we need to keep a healthy distance and reject the notion that markets are always right. Bravo Nicole !