Chapter 2: risks, markets and contracts

Question 1

Concept of risk

Answer 1

1) Future is uncertain
2) uncertainty translates into risk: in this case, risk of loss of income 3) risk equals probability X consequences
4) doing business means excepting some risks 5) willingness to accept risk that varies: venture capitalists versus retiree
6) ability to control risk varies: professional traders versus novice investors

Question 2

Sources of risk

Answer 2

1) Technical risk
2) external risk
3) price risk

Question 3

Technical risk

Answer 3

Failure to produce or deliver because of technical problem: power plant outage, congestion in the transmission system

Question 4

External risk

Answer 4

Failed to produce or deliver because of cataclysmic event: Weather, earthquake, war

Question 5

Price risk

Answer 5

• Having to buy at a price much higher than expected

- having to sell at a price much lower than expected

Question 6

Managing risks: excessive risk hampers economic activity

Answer 6

• Not everybody can survive short-term losses
• Society benefits of more people can take part
• Business should not be limited to large companies with deep pockets

Question 7

How can risk be managed

Answer 7

• Reduce the risk
• Share the risk
• Relocate the risk

Question 8

Reducing the risks

Answer 8

• Reduce frequency or consequences of technical problems
• Reduce consequence of natural catastrophes
• Security margin in power system operation

Question 9

Reduce frequency or consequences of technical problems

Answer 9

Those who can reduce risk should have an incentive to do it: owners of power plants

Question 10

Reduce consequences of natural catastrophes

Answer 10

• Owners and operators of transmission system

- design systems to be able to withstand rare events : enough crews to repair the power system after a hurricane

Question 11

Security margin in power system operation

Answer 11

• Limits the consequences of rare but unpredictable and catastrophic events
• increases the daily cost of electrical energy
• does not cover all possible problems because that would cost too much

Question 12

Sharing the risks

Answer 12

• Insurance

- Grid operator does not have to pay compensation in the event of a blackout

Question 13

Showing the risks: insurance

Answer 13

• All the members of large group pay a small amount to compensate the few who suffer a big loss
• the consequences of a catastrophic event are shared by a large group rather than a few

Question 14

Relocating risk

Answer 14

• Possible if one party is more willing or able to accept it: loss is not catastrophic for this party, this party can offset this loss against gains in other activities
• applies most to price risk
• how does this relate to markets?

Question 15

Characteristics of markets

Answer 15

• The time of delivery of the goods
• the mode of settlement
• any conditions that might be attached to this transaction

Question 16

Spot market

Answer 16

Immediate market, on the spot:
-agreement on price 
– agreement on quantity 
– agreement on location
-unconditional delivery
-immediate delivery

Question 17

Examples of spot markets

Answer 17

Can be formal or informal:

• food market
• basic shopping
• Rotterdam spot market for oil
• commodities markets: corn, wheat, cocoa, coffee

Question 18

Sports markets: advantages

Answer 18

– Simple
-flexible
– immediate

Question 19

Spot markets: disadvantages

Answer 19

-Prices can fluctuate widely based on circumstances
– example: effect of frost in Brazil on the price of coffee beans, effect of trouble in the middle east on the price of oil

Question 20

Spot market risks

Answer 20

• Market may not have much depth
• lack of depth causes large price fluctuations
• relying on the spot market for buying or selling large quantities is a bad idea

Question 21

Spot market may not have much depth

Answer 21

• Not enough sellers: market is short

- not enough buyers: market is long

Question 22

Spot market: lack of depth causes large price fluctuations

Answer 22

-Smaller producer may have to sell at a low price
-small purchaser may have to buy at a high price
– price risk

Question 23

Forward contract

Answer 23

– Agreement: quantity and quality, price, date of delivery (not immediate)

• Paid at time of delivery
• unconditional delivery

Question 24

How is the forward price set?

Answer 24

-Both parties look at the alternative: spot price

– both forecast what the spot price is likely to be

Question 25

Forward contracts: sharing risk

Answer 25

-In a forward contract, the buyer and the seller share the risk that the price differs from the expectation
– difference between contract price and spot price at time of delivery represents a profit for one party and a loss for the other
-however, in the meantime they have been able to get on with the business: buy new farm machinery, sell the flour to bakeries

Question 26

Attitude towards risk: expires less risk averse than seller

Answer 26

• Buyer can negotiate a forward price lower than the expected spot price
• seller agrees to this lower price because it reduces its risk
• difference between expected spot price and forward price is called a premium
• premium equals price that seller is willing to pay to reduce risk

Question 27

Attitudes towards risk: if by a small risk averse than seller

Answer 27

• Seller can negotiate a forward price higher than the expected spot price
• buyer agrees to this higher price because it reduces its risk
• buyer is willing to pay the premium to reduce risk

Question 28

Diversification

Answer 28

• Diversification: deal with more than one commodity
• Average risk of different commodities
• farmers may not want to diversify the production because it could be inefficient

Question 29

Physical participants

Answer 29

-Produce, consume or can store the commodity

– face undiversified risk because they deal in only one commodity

Question 30

Traders a.k.a. speculators

Answer 30

• Cannot take physical delivery of the commodity
• diversify the risk by dealing in many commodities
• specialise in risk management

Question 31

Trading by speculators

Answer 31

• Cannot take physical delivery of the commodity
• must balance their position and date of delivery: quantity bought must equal quantity sold, buy or sell from spot market if necessary
• may involve many transactions
• forward contracts limited to parties who can take physical delivery
• need a standardised contract to reduce the cost of trading: future contract
• future contracts (futures) allow others to participate in the market and share the risk

Question 32

Importance of information: speculators

Answer 32

-Speculators own some of the commodity before it is delivered
-they carry the risk of a price change during that period
-need deep pockets
– without additional information, this is gambling
-information helps speculators make money
-example: global perspective on the harvest for wheat, long-term weather forecast and it’s effect on the demand for gas and electricity

Question 33

Options

Answer 33

• Spot, forwards and future contracts: unconditional delivery
• options: conditional delivery:call option, put option
• two elements of the price

Question 34

Call option

Answer 34

Right to buy at a certain price at a certain time

Question 35

Put option

Answer 35

Right to sell at a certain price at a certain time

Question 36

Two elements of the price

Answer 36

• Exercise or strike price equals prize paid one option is exercised
• premium or option fee equals price paid for the option itself

Question 37

Two-way contract for difference

Answer 37

Combination of a call and put option for the same price➡️ will always be used