Professor Craig Pirrong

**Phone** 713-743-4466

**E-mail** cpirrong@uh.edu and cpirrong@gmail.com . **Note: Please send all large files (exams, HW, etc.)
to the cpirrong@gmail.com
account!!! Too many big files crash my
UH email. **

**COURSE DESCRIPTION**

This course provides an overview energy derivatives markets and the pricing of energy derivatives including forwards, futures, swaps, and options. We will begin by describing what futures and swap contracts are and how they are traded. We will then analyze how to price futures and swaps on energy commodities, and how the prices of these derivatives behave under varying market conditions. This will be followed by a description of the basics of option contracts. The course will then explore some simple no-arbitrage restrictions on the pricing of options. This will be followed by an analysis of two options pricing models, the binomial model and the Black model. The course will discuss in detail the assumptions underlying these models and the consequences of the violation of these assumptions. We will also discuss option risk, option hedging, exotic options and real options.

You can download the overhead slides used in the
lectures from my web page. You can also
download the manuscript for my forthcoming book, *Structural Models of Commodity Price Dynamics*, which is a useful
supplement for the mathematically-inclined.

The grading for the course is based on up to five homeworks and a final. The homework counts for 33 percent of your grade; the final for the remaining 67 percent.

*16
January-30 January. An Introduction to Energy Derivatives & Energy Trading.
*In this week we will describe futures contracts, learn how they are traded,
and analyze their purpose. We will
examine concepts such as arbitrage, delivery, hedging, basis, basis risk, and
clearing. There will also be an
examination of the basics of energy trading, focusing on the transformations
(over time, space, and form) in energy, and how trading can help maximize the
value of these transformations. We will also analyze the pricing of contracts
on precious metals as an introduction to arbitrage and as a standard of
comparison to energy markets. We will
also learn about the pricing of energy swaps. *Reading**: *

*NYMEX Energy Products**NYMEX Energy Hedging Brochure**CME Price Risk Management Guide**CME Clearing Overview**Pirrong WTI Hedging Performance Study**Purvin Gertz Crude Oil Fundamentals Study*

**NO CLASS 7 FEBRUARY. **

*13 February.
Storable Commodity Derivatives. *Many
of the most important energy products, such as natural gas, crude oil, and
products are storable. Understanding the
behavior of forward curves for these commodities, and the dynamics of storables prices, requires an analysis of the optimal
allocation of commodities over time. To
gain this understanding, we will analyze the “theory of storage” and its
implications for commodity futures pricing.
We will discuss backwardation and contango,
the determinants of the shape of energy forward curves, and the relation
between the shape of the curve and the volatility of prices. We will also discuss how the actions of
large traders can distort prices and price relations, and how this can impact
hedgers in the marketplace.

·
*Pirrong, “Squeezes,
Corpses, and the Anti-Manipulation Provisions of the Commodity Exchange Act” (Regulation,
1994). *

·
*Pirrong, “Energy
Market Manipulation: Definition, Diagnosis, and Deterrence” (Energy Law
Journal, 2010).*

·
*Pirrong Manipulation Review, Journal
of Commodity Markets*

*20 February. Hedging and Risk Measurement
Basics.* This section will discuss how to use
statistical methods to design variance minimizing hedges, and the implications
of the theory of storage for hedge design and hedging effectiveness. I will also examine basic risk measurement
methods, focusing on value at risk.

*27 February.
Non-Storable Commodity Derivatives and Credit Derivatives*. Recently,
non-storable commodity derivatives have been introduced and exhibited rapid
growth. These include derivatives on
electricity and weather. This week we
will discuss the pricing of such derivatives.
Credit derivatives—contracts on the credit risk of corporations—are
another major growth area. We will
discuss the types of credit derivatives currently traded and their use.

*5
March. Speculation and Commodity Pricing*. Speculation is a controversial subject in
commodity markets. We will examine the
economics of speculation, and its effects on prices. We’ll then consider the potential for
speculation to distort prices, and the evidence relating to the effects of
speculation. Finally, we will analyze
the rationale for limits on speculation, notably position limits.

·
*Pirrong, “No Theory?
No Evidence? No Problem” (Regulation, 2010).*

*Note! No Class on 12 March, 2020. Spring Break!*

*19
March. Introduction to Options. *We
will describe the basics of put and call options, and discuss briefly how puts
and calls can be combined to create more elaborate payoff patterns. We will
also examine the determinants of early exercise of American options. Finally,
we will analyze put-call parity and other restrictions on option price
relations.

*NYMEX
Brochures:*

*26 March- 2 April. The Binomial Model. *In
order to price options, it is necessary to utilize a model that characterizes
how futures prices evolve over time. The binomial model is a simple and
tractable example of such a model. We will describe the binomial model and show
how to use it to price simple options.
We will then extend the analysis to learn how to use the model to price
options for which early exercise is relevant.

*9-16 April. The Black Model. *Under certain
assumptions the binomial model converges to the Black model. This model is the
one most commonly used to price options. We will discuss the derivation of the
model briefly, and then proceed to use it to price options.

*23 April. Options Risks and Hedging—“The
Greeks.” * This week we will analyze
how the Black model can be used to quantify options price risk. We will also discuss how to
manage—hedge—options risks through dynamic trading strategies and how to
replicate options using such strategies.
Options introduce non-linearities that
complicate risk measurement. This week
we will also discuss how to incorporate options into the VaR
framework.

**Take Home Final Exam Due 30 April, 2020***.*

**ABOUT YOUR INSTRUCTOR**

I joined the UH faculty after spending 14 years
teaching at the Michigan Business School, Graduate School of Business at the
University of Chicago, the Olin School of Business at Washington University,
and Oklahoma State University (where I held the Watson Family Chair in
Commodity and Financial Risk management).
I received my BA, MBA, and Ph.D from