Hedging Strategy and Electricity Contract Engineering - IFOR

3.4 Traditional risk management models 57
vantage is that it requires very accurate historical prices of all positions in the
portfolio, which in many cases do not exist. In the electricity market the majority
of contracts are still OTC with no price history. The historical simulation
is therefore not a good approach in the power market.
Monte Carlo simulation In the Monte Carlo approach a large number of
scenarios are generated based on the assumptions made about the stochastic
processes driving each position. The portfolio is then assessed in each scenario
and the quantile, VaR is calculated. The approach is very flexible, but
hence subject to subjectivity. It has the disadvantage of using large computer
power. Because of the complex contracts and the complicated stochastic price
process in the electricity market the flexibility of the Monte Carlo approach is
however needed, why this approach seems to be best suited for electricity risk
management purposes.
Extreme value theory In the three approaches mentioned above one always
has the problem of estimating VaR outside the data sample for high quantiles.
Extreme value theory can then be used to extrapolate outside the observed sample,
to estimate the size of a yet unseen disaster [EKM97].
3.4.1.4. Stress test
The stress test is normally conducted as a compliment to the VaR calculation,
but it can also be used as a stand-alone risk measure. First a potential movement
within the time horizon in the underlying risk factors is defined. That could,
for example, be a 200 basis point shift in the yield curve or a 30% shift in all
equity positions or a foreign exchange movements of 15%. Then the loss that
would occur given these shifts is calculated, which serves as an estimate of the
risk in the portfolio. No dependencies are taken into account, why stress test is
conservative and very blunt. The advantage is its simplicity, but it is strongly
recommended that a more sophisticated measure should be used instead of, or
in addition to, stress test.