How to gain from risk premia

Premium by month
As an alternative, we can examine the data to determine the risk premium for specific contract months. For this exercise, we examine dollar price changes for specific contract months, such as the January contract, for the twelve months prior to their expiration. The results of this analysis are shown in figure 2.

While we might initially expect to see a higher risk premium during the higher-priced winter months, we instead see significantly higher risk premia for the April and May contracts as well as for the October, November, December and January contracts. The summer and mid-winter months have lower risk premia. These contracts roughly match the ‘shoulder’ months1 of natural gas trading, when there is greatest uncertainty and risk over actual gas consumption.

The volatility risk premium
Our analysis seems to indicate the overall presence of a positive risk premium in gas prices. Standard option pricing models usually make the assumption that the forward price is an unbiased estimator of the spot price. If the option pricing models ignore the risk premia, they may be underpricing some options.

To test this, we evaluated the price of at-the-money call and put options2 one month to expiration. We then calculated the value of the option at expiration. If the option is fairly priced, the value of the option at expiration less the option premium should, on average, be zero. The results indicated that, on average, buying a call option with one month to expiration led to a loss of $0.01/mmBtu and buying a put option led to a loss of $0.02/mmBtu.

These results imply the presence of a different type of risk premium – a volatility risk premium. In this case, the writers of options receive a premium for taking the option risk. This premium is bigger than other risk premia that might exist in the natural gas market.

While the calculated risk premium is small and only marginally significant, smart traders and hedgers use this information when developing their strategies. Traders may want to tilt their strategy to being long – and long the shoulder month contracts in particular – due to the risk premia. We would expect to make a few cents due to the risk premia from such trades. Hedgers, on the other hand, would want to select the hedging strategy where they pay the least risk premia for the protection. Given the risk premia paid to writers of options, hedgers might more actively consider using written options in their hedge strategies.

While the risk premium is not a guaranteed return and there is still a substantial chance of loss, good traders and hedgers will do the most they can to swing the odds in their favour.

Brett Humphreys is a consultant at Risk Capital Management in New York.
e-mail: humphreys@e-rcm.com