A simple answer to many of the above problems is to use implied rather than
historical volatilities. This provides a particularly useful solution for monitoring
option positions in liquid markets. However, they are less useful for the less liquid
positions for applying VaR in energy.
The principal reason for this is the level of liquidity in the option market. Without
a full-volatility ‘smile’ (i.e. the volatilities across a range of in- and out-of-the-money
strike prices) and option pricing for a range of contract terms it is difficult to see fully
how the market perceives volatility. For instance, you would want to break out the
volatility most consistent with your VaR confidence interval for each forward contact.
While this is possible in very liquid products such as crude oil it is difficult in gas
and impossible in power.
The other problem is ensuring a consistency when using volatilities within models
such as covariance matrices. Unless all your volatilities are calculated on a consistent
basis, cross-correlations will not be consistent.
Given the option liquidity problems it is generally easier to use historical volatilities
and ‘test them’ against the implied numbers that are available from the market.
From this you can recalibrate the volatility models to the market numbers rather
than fit to historical numbers, probably as a stress test.
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