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FRSGlobal Fine Tuning Fair Value Pricing Models for Emission Linked Derivatives, Says Brammertz

Risk and regulatory reporting solution vendor FRSGlobal is currently endeavouring to develop new valuation models in order to gauge the fair value prices of emission linked derivatives contracts, according to Willi Brammertz, senior risk advisor at the vendor. Although political concerns are holding back some degree of progress with regards to these new instruments, Brammertz is confident that Europe is moving forward enough for vendors to begin dipping a toe in the water of this new area of financial instrument development. FRSGlobal is eventually planning to add this new functionality to its RiskPro platform.

The vendor is currently working with Institute of Data Analysis and Process Design of Zurich University of Applied Science (ZHAW) in order to begin developing the models. The research thus far has focused on the modelling of the martingale dynamics of futures contracts on emission allowances and the implementation of quasi closed-form expressions for European call options on emission allowance futures, says Brammertz. The goal is eventually to add the new valuation and risk modelling capabilities to the vendor’s RiskPro offering by the end of this year or the start of 2011.

Brammertz indicates that although progress has been slow with regards to political agreement over the new carbon trading regime, Europe is already into the second phase of development. Australia and New Zealand are also making some progress to this end and even the US is poised for action, he adds. The increasing liquidity in trading futures on greenhouse gas emission allowances has therefore led to the trading of emission linked derivatives.

“The cap and trade system of the new market for carbon trading has been designed by economists in order to solve an environmental issue,” explains Brammertz. “But there is currently no theoretical foundation for pricing of the related instruments such as emission linked derivatives.”

This is where FRSGlobal is hoping its experience in risk model development will reap rewards. It is aiming to enable RiskPro to provide a reliable model calibration technique based on historical prices of emission allowances and Brammertz indicates that the initial goal is to link the production world with the financial industry.

“There has long been a dichotomy between the world of finance and the world of production and there has traditionally been a split between financial analysis of both spaces. The financial side of the equation is usually based on static risk modelling, whereas production tends to use dynamic models. After all, non-financial industries lend themselves to more dynamic analysis,” he elaborates.

Brammertz reckons that RiskPro can offer the common language for the two sides, which have been incommunicado for too long. “The advanced simulation techniques allow for the first time to join the real production and the financial side of any industry – including the ones producing CO2 – and see the full financial consequences of any strategy,” he contends.

The calibrations will be based on historical future prices and Brammertz indicates the vendor is looking to the Hinz model initially. The value at risk (VaR) of the commodities derivatives will also be part of the overall picture but dynamic analysis will be added to this static analysis to ensure all factors are included. Brammertz has previously discussed the limitations of the VaR model and the need for this type of analysis to be set into a more holistic risk modelling context.

“The Hinz model has been back tested and has been favourably compared to the Black-Scholes model. However, a lot of calibration is ongoing and will continue in order to make sure it is taking into account the various scenarios and variables of the market,” he adds.

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