Variability Swaps VI.

The goldilocks principle, incremental development

This series is about exploring interesting conceptual connections between energy market instruments and variance swaps. The theory of variance swaps and volatility in the capital markets is comparatively mature and the aim is to see if we can use some of this maturity to inform our thinking about developments in the energy markets. Links to previous instalments: I, II, III, IV, V.

It’s fascinating to follow the development of financial instruments in the energy markets at the moment. Approaches are converging. Increasingly, standardised contracts are developing to form a toolbox.

One of the biggest challenges in the renewable energy market has been the lack of standardised products that can be easily quoted, traded, and compared across multiple market participants. Historically, PPAs have been complex, bespoke contracts with limited price transparency, making it difficult for companies to assess fair value and efficiently manage their risks. enmacc

Over time, market participants become increasingly comfortable with their ability to work with risk. You are comfortable with risk if you feel you understand it and are able to act on that understanding. Models express understanding and reliable hedging strategies provide a way to act.

Once a sense of comfort has developed around a well-known range of risk profiles, the next step is to identify risk profiles that are outside the comfortable domain and for which there may be a market.

If a new risk profile is too far away from existing models and hedging strategies, it will be too difficult to form a view on it. Risk managers will feel uncomfortable, it will be too difficult to build a market. If the new risk profile is too close to the existing ‘comfort zone’ it is redundant and uninteresting, not enough new value.

New financial instruments thus emerge through a sort of ‘goldilocks principle.’ The new space of risk can’t be too far removed from what market participants can handle, nor too close so as to be essentially redundant.