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2023 | Buch

Virtual Barrels

Quantitative Trading in the Oil Market

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The global oil market is no longer solely influenced by the supply and demand of physical oil barrels. In today's landscape, financial barrels traded by hedge funds using quantitative algorithms and dealers managing large portfolios of oil derivatives are equally crucial in determining the price of oil. This book offers a fascinating insight into the world of oil derivatives, exploring the quantitative models and trading strategies used by professional market participants. With a focus on oil options and volatility trading, the reader is taken on a journey through the story of this market, narrated by one of its pioneers who managed a highly successful trading business for almost a quarter of a century. Bridging the fields of energy economics and mathematical finance, this book demonstrates how the science of trading can unearth unique opportunities in the oil market. Written for aspiring quantitative traders and academic researchers alike, it offers a rare glimpse into the opaque and secretive world of oil derivatives, showcasing how it operates in practice.

Inhaltsverzeichnis

Frontmatter
1. Introduction
Abstract
Global oil trading is an example of a complex dynamic system, where everything depends on everything else, and system components communicate with each other via multiple feedback loops. The oil trading system revolves around real options embedded in physical assets. Energy assets are expensive to build and given the high sensitivity of their economics to forward prices, the corresponding risks must be eliminated by hedging. This creates a thriving market for financial barrels the magnitude of which exceeds the market for physical barrels by a large factor.
Ilia Bouchouev

Economic Foundations, Markets, and Participants

Frontmatter
2. Oil, Money, and Yields
Abstract
By looking at a hypothetical economy where oil and US dollar function as two alternative standards of money, we arrive at the replica of the Fisher inflation law, which can be seen as the first rigorously defined quantitative carry trade. We revive a largely forgotten Keynesian concept of commodity own rate of interest and show how it relates to the convenience yield in the physical market and the roll yield in trading futures.
Ilia Bouchouev
3. Fundamentals, Storage, and the Model of the Squeeze
Abstract
We use the conventional storage theory to illustrate the dynamic feedback loop between prices and inventories and highlight the challenge of its practical applications to the oil market. We then borrow some concepts from the physics of extreme events and develop a more practical alternative approach to the storage problem. We call it a stylized model of the squeeze. For an example of such a squeeze, we delve into the infamous episode of negative oil prices.
Ilia Bouchouev
4. Financialization and the Theory of Hedging Pressure
Abstract
In this chapter the focus shifts to flow imbalances. Particular attention is paid to causes and consequences of the influx of financial investors to the oil market, the phenomenon dubbed financialization. We track the market transition from the early days of normal backwardation to the subsequent regime of normal contango and combine them into a more general economic framework that describes the hedging pressure equilibrium.
Ilia Bouchouev

Quantitative Futures Strategies

Frontmatter
5. Systematic Risk Premia Strategies
Abstract
This chapter is devoted to systematic quantitative funds, known as commodity trading advisors (CTAs) or simply as algos. These traders tend to look at markets through the lenses of risk premia, such as momentum, carry, and value. We discuss how the source of these risk premia in the oil market is ultimately linked to the theory of storage. Important concepts of signal blending and the reaction function are introduced.
Ilia Bouchouev
6. Quantamentals
Abstract
In this chapter, we explore the considerably more challenging task of using fundamental data for generating trading signals, and the class of semi-systematic strategies, colloquially referred to as quantamentals. We discuss the convergence strategy of WTI-Brent accordion and extend the concept to construct a broader statistical arbitrage portfolio of energy pairs. We use the technique of fractionation to incorporate inventories and provide additional ideas for modeling flows and positioning.
Ilia Bouchouev
7. Macro Trading
Abstract
We look at oil as a sub-component of a broader macro trading system. We illustrate oil linkages to currency, equity, and fixed income markets with three cross-asset relative value strategies. We conclude by constructing a simple and somewhat naïve fair value model for the price of oil. While this model is built on questionable theoretical grounds, it is a good example of when something that should not work in theory turns out to be helpful in practice.
Ilia Bouchouev

Volatility Trading

Frontmatter
8. Options and Volatilities
Abstract
This chapter summarizes the main building blocks that make up the business of volatility trading. It starts by covering remarkable contributions of Louis Bachelier whose a century-old pricing formula is still being used by oil traders. The classical Black-Scholes-Merton framework of option replication is then presented in a more general setting of diffusion processes. We highlight the importance of distinguishing between three commonly used types of volatility: local volatility, realized volatility, and implied volatility.
Ilia Bouchouev
9. The Hidden Power of Negative Gamma
Abstract
This chapter looks at writing oil options from the perspective of the insurance product, which is the essence of gamma trading and the resulting volatility risk premium. We dissect the historical performance of various strategy specifications from multiple angles, introduce the concept of the VRP smile, and identify regime breaks caused by changing behavior of large market participants.
Ilia Bouchouev
10. Volatility Smile Trading
Abstract
We study the problem of the volatility smile and the strategy of vega trading. We demonstrate limitations of conventional paradigms to the oil market and use a more flexible framework of diffusion processes. We apply the technique of perturbation methods to develop a novel quadratic normal model. This model corrects the Bachelier formula for skewness and kurtosis with the three model parameters mapped to the three primary option benchmarks in the oil market.
Ilia Bouchouev

Over-the-Counter Options

Frontmatter
11. Volatility Term Structure and Exotic Options
Abstract
We describe arguably the most significant oil derivative trade, the large-scale annual put buying program by the Government of Mexico. The complexity of over-the-counter deals highlights the importance of handling the volatility term structure and the effect of volatility dampening by price averaging. A simplified and more practical model for pricing and hedging average price options, which are popular among end-users, is presented. Swaptions and other exotic derivatives are also discussed.
Ilia Bouchouev
12. Volatility Arbitrage and Model Calibration
Abstract
This chapter focuses on the important problem of model calibration. We present the bootstrapping method for calibrating volatility time-dependency and back out market-implied probability distribution from option prices. We then outline a more difficult problem of reconstructing the underlying diffusion process. Some readers may find it interesting that this problem, known as the inverse problem of option pricing, in its general case presents a rare example of an unsolved mathematical problem.
Ilia Bouchouev
13. Spread Options and Virtual Storage
Abstract
We present a trading strategy based on the idea of virtual storage. The physical storage asset is replicated with a financial derivative, a calendar spread option, and the structural pricing dislocation between the physical and financial market is exploited. Other spread option and correlation strategies are based on the concept of a triangular arbitrage, which links prices of vanilla and spread options. We emphasize some flaws of correlation-based models and argue for a closer connection to fundamentals in modeling volatility of energy spreads.
Ilia Bouchouev
14. Epilogue
Abstract
With the energy transition the market for financial energy derivatives will expand but continue to function as a complex dynamic system with multiple feedback loops revolving around optionality embedded in physical assets. While the nature of these assets will undoubtably evolve, the core quantitative principles which describe the assets will remain remarkably similar, such as batteries becoming the new form of the energy storage. Thus, many concepts described in this book may well find new applications, and during the energy transition the market for virtual barrels could serve as the blueprint for the broader market for virtual commodities.
Ilia Bouchouev
Backmatter
Metadaten
Titel
Virtual Barrels
verfasst von
Ilia Bouchouev
Copyright-Jahr
2023
Electronic ISBN
978-3-031-36151-7
Print ISBN
978-3-031-36150-0
DOI
https://doi.org/10.1007/978-3-031-36151-7