Probabilistic Standards: Carbon Alpha

Introduction:

Markets that rely on probabilistically defined underlyings are essential for managing uncertainty and risk in various sectors. These markets use statistical models to define their core measures, allowing for accurate risk assessment and pricing. This probabilistic approach ensures fungibility, meaning that the units of trade are standardized and interchangeable, enabling seamless transactions across different markets and contracts. Without this probabilistic foundation, it would be impossible to accurately price and share risk, as the inherent uncertainties and variabilities could not be effectively quantified or managed. This ensures that market participants can hedge against risks and invest with confidence, knowing that the underlying measures are reliable and consistent.

Market Examples and Probabilistic Measures:

1. Weather Derivatives Market: Degree Days (HDD/CDD): Probabilistically defined based on temperature data, typically using measures like P50 (median forecast) or P90 (more conservative forecast). The probabilistic measure ensures accurate modeling of energy demand, crucial for hedging weather-related risks.

Market Size: $12 billion annually.

Underlying Market: $100 billion to $300 billion.

2. Catastrophe Bonds (Cat Bonds) Market: Catastrophic Event Parameters: Modeled probabilistically based on historical data and scientific simulations, often using P50 or P95 conditions to estimate the occurrence and severity of predefined natural disasters. These probabilities help insurers and investors gauge the likelihood and impact of catastrophic events.

• Market Size: $30 billion to $40 billion.

• Underlying Market: $5 trillion.

3. Longevity Bonds Market: Life Expectancy and Mortality Rates: Probabilistically derived using demographic and actuarial data, often employing P50 (median) or P70 (70th percentile) conditions to ensure accurate estimation of life spans for large populations.

• Market Size: A few billion dollars.

• Underlying Market: $25 trillion.

4. Electricity Price Derivatives Market: Electricity Prices: Probabilistically forecasted based on weather patterns, demand and supply conditions, and regulatory changes, typically using P50 or P90 conditions. This probabilistic definition captures the inherent volatility of electricity prices.

• Market Size: $300 billion annually.

• Underlying Market: $2 trillion annually.

5. Volatility Indices (e.g., VIX) Market: Implied Volatility: Derived probabilistically from the prices of options on the S&P 500 index, often using P50 conditions to reflect market expectations of future volatility. This ensures that the volatility measure represents a balanced view of potential market movements.

• Market Size: $2 trillion in notional value.

• Underlying Market: $30 trillion.

6. Carbon Alpha Tokenised Tonne of Carbon Abatement Market: Carbon Abatement: Defined probabilistically to 99.5% accuracy under P90 conditions. This ensures high reliability in measuring abated carbon, facilitating trading and investment in carbon reduction initiatives.

• Market Size: Projected to reach $5 trillion by 2030.

• Underlying Market: Delivers pricing signals and alpha to underlying equities, bonds, and currencies markets valued at approximately $3 quadrillion.

Explanation of Probabilistically Defined Underlying risk:

1. Weather Derivatives: The underlying asset, such as Heating Degree Days (HDD) and Cooling Degree Days (CDD), is probabilistically defined based on temperature data. This approach is essential as weather patterns are inherently uncertain and variable. Probabilistic measures allow accurate modeling of energy demand for heating or cooling, ensuring the fungibility of outcomes across different contracts and markets.

2. Catastrophe Bonds: The underlying in Cat Bonds is the occurrence and severity of predefined natural disasters, modelled probabilistically based on historical data and scientific simulations. This is the only viable underlying, capturing the risk of catastrophic events accurately. The fungibility of these bonds is maintained through standardized modeling practices and data.

3. Longevity Bonds: The underlying asset in longevity bonds is based on probabilistic measures of life expectancy and mortality rates, derived from demographic and actuarial data. This probabilistic definition is crucial as individual life spans are uncertain but can be statistically estimated for large populations. Standardized actuarial methods ensure these bonds’ fungibility.

4. Electricity Price Derivatives: The underlying asset in these derivatives is probabilistically defined and forecasted based on factors such as weather patterns, demand and supply conditions, and regulatory changes. This is the only feasible underlying as electricity prices are highly volatile and influenced by multiple stochastic factors. Probabilistic modeling ensures fungibility across different markets and conditions.

5. Volatility Indices (VIX): The underlying measure in volatility indices like the VIX is implied volatility, probabilistically derived from the prices of options on the S&P 500 index. This is the only possible underlying because market expectations of future volatility are inherently uncertain and best captured through option pricing models. This ensures that volatility indices are fungible across different financial instruments and markets.

6. Carbon Alpha Tokenized Tonne of Carbon Abatement: The Carbon Alpha token represents an abated tonne of carbon, probabilistically defined to 99.5% accuracy under P90 conditions. This is the only possible underlying as carbon abatement involves complex and uncertain emission reduction processes. The probabilistic definition ensures high accuracy and reliability, making the tokens fungible and standardized for trading and investment. The Carbon Alpha token market, projected to reach $5 trillion by 2030, significantly impacts global financial markets valued at $3 quadrillion, providing essential pricing signals and alpha.

Conclusion:

In each of these markets, the probabilistic definition of the underlying asset or measure is essential to accurately capture inherent uncertainties and risks. This approach ensures that outcomes are fungible, allowing for standardization and seamless trading across different markets and contracts. The probabilistic foundation provides a consistent and reliable basis for pricing, risk management, and investment decisions.