Advocacy Paper for CFA® Institute
The CFA curriculum was not only intellectually fascinating, but it added enormous value to me—and, I dare to say, to Axpo Trading, the organization that I’ve had the privilege of leading.
Axpo Trading is one of the leading energy trading companies in the European power and gas markets. The company has also recently started its activities in the US power and gas markets. Axpo counts on about 700 very motivated employees located in offices in 30 countries. My company’s core business is based on three main pillars:
Asset-backed trading: We monetize the optionality embedded in our physical assets (power plants, gas storage, and LNG).
Origination: We risk-manage the energy exposure of our customers (renewable power plants, industrial customers, and retailers) through bespoke hedging products.
Fundamental trading: Based on fundamental analysis, we take positions (long or short) in power, gas, coal and oil spot, forward, future, and option markets.
All these activities are interlinked, but require a different skill set and approach. One may wonder what a CFA curriculum has to do with such a business. In fact, it has a lot to do with the activities we carry out, particularly in regard to the three main topics that are covered in the CFA program: risk management and derivatives, portfolio theory, and behavioral biases in commodity trading.
Risk Management and Derivatives
The financial theory of equity and fixed income, Black–Scholes option pricing, and derivatives (swaps, forwards, and futures) is the basic introduction into the fascinating world of commodities risk management. It’s the starting point, but the commodity world quickly becomes more complex.
Commodity spot price development, for example, doesn’t usually follow Brownian motion, as prices tend to react to real physical constraints and can easily jump up and down based on mismatches between demand and supply. This reaction can be even more pronounced for commodities with low or no ability to store, like electricity. For similar reasons, commodity prices (spot and forward) exhibit much fatter tails than equity prices. Supply and demand analysis to estimate the fair value of a commodity is far more relevant than for securities like equities or bonds.
Short selling, completeness, and liquidity of the underlying markets are minimal requirements for applying sound derivatives theory. Often, imperfect conditions can be accepted, and risk management principles still hold. But what if all these assumptions do fail (which frequently happens in the commodity market)?
The forward spot linkage is more complex than in equities due to the presence of cost of storage and convenience yield. Consider power trading: power is not directly storable.
Closed-form solutions are commonly insufficient for pricing. In most cases, Monte Carlo stochastic simulation is more appropriate. The theory is generally less developed for commodities than for equities or bonds, which increases the fascination of the discipline and attracts young talent that will gladly accept the challenge.
Portfolio Theory
Modern portfolio theory (MPT), pioneered by economist Harry Markowitz, also has relevance to the matter. In a classical financial security portfolio, equities and bonds are principal instruments; commodities are viewed as an alternative asset class, because they often don’t have similar long-term macroeconomic cycles and have their own dynamics in the short term (we know, however, in major financial crises, all markets speak the same language).
In our case, the starting point is different in the sense that we don’t build an investment portfolio, but manage a portfolio of complex derivatives and underlying commodities that we inherit from our service and product offerings. And the core activity is to hedge the inherent risk with tradeable products offered by the market. We end up warehousing spread risks between different commodities, tenors, and locations. So the foundational analysis underlying MPT becomes critical: The best hedge is one that optimizes the risk return of the spread risk portfolio. We need to assess drift, standard deviation, and correlation among the commodities and spreads. Different data, same challenges. While volatility can be estimated with some comfort, drift and correlation are much more critical.
Behavioral Biases in Commodity Trading
Both commodity trading and financial securities meet the everyday reasoning and decision making criteria, and both fall under similar biases. Among many biases that “badly” influence decision making, anchoring and overconfidence are clearly observable in the commodities and financial markets.
Anchoring bias is the use of irrelevant information, perhaps the first piece of information offered (the "anchor") as a reference for evaluating some unknown value. Historical values—such as acquisition prices, high-water marks, or long periods of low or high prices—are common anchors. The initial price offered for a used car sets the standard for the rest of the negotiation, regardless of the legitimacy of the initial price. The illusion of control is the overconfidence that one knows the truth. Rolf Dobelli once stated, “We systematically overestimate our knowledge and our ability to predict—on a massive scale. And it’s not counterbalanced by the opposite effect, ‘underconfidence,’ which doesn’t exist.
The stock market crash of 1929 is still the most significant crash in US history. Since 1922, the stock market had gone up, not down, nearly 20% a year, and as such, all forecasts were bullish. Between October 24, 1929, the so-called “Black Thursday,” and October 29, 1929, “Black Tuesday,” the Dow Jones alone lost over USD 30 billion in market value. Energy markets in 2008 manifested a similar pattern nobody could imagine. Any bias? It’s worth taking a look at “The evidence on the folly of forecasting is overwhelming,” by James Montier.
Ultimately, through almost 20 years of work experience, I’ve had the opportunity to experiment with many topics learned through the CFA curriculum in many fields within our organization: portfolio theory, removing biases, quantitative and corporate finance. It’s not only been a great pleasure to experience the CFA, but also a major contribution to my professional career.
About the Author:
Domenico De Luca, CFA, MBA, is the CEO of Axpo Trading.