Energy Derivatives

Sonal Gupta
Agenda
History
Introduction to Exchange
Open outcry system
Instruments
Types of Traders

History
The first exchange for trading derivatives appeared
to be the Royal Exchange in London, which permitted
forward contracting of tulip bulbs around 1637.
The first "futures" contracts are generally traced to the
Yodoya rice market in Osaka, Japan around 1650
Chicago Board of Trade in 1848 - Chicago was a major
center for the storage, sale, and distribution of
Midwestern grain. These central marketplaces provided
a place for buyers and sellers such as farmers and
grain dealers to meet, set quality and quantity
standards, and establish rules of business.

5
Futures/Forward Contracts -
History
By 1870s these forward contracts had become
standardized (grade, quantity and time of delivery)
and began to be traded according to the rules
established by the Chicago Board of Trade
(CBOT)
The Chicago Mercantile Exchange was
established in 1919.

6
Futures/Forward Contracts -
History Contd
1891 the Minneapolis Grain Exchange
organized the first complete clearinghouse
system
the clearinghouse acts as the third party to all
transactions on the exchange
designed to ensure contract integrity
buyers/sellers required to post margins with the
clearinghouse
daily settlement of open positions - became known as
the mark-market system
7
Futures/Forward Contracts -
History Contd
Key point is that commodity futures (evolving from
forward contracts) developed in response to an
economic need by suppliers and users of various
agricultural goods initially and later other
goods/commodities - e.g metals and energy
contracts
Financial futures - fixed income, stock index and
currency futures markets were established in the
70s and 80s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets
8
Option Contracts - History
Chicago Board Options Exchange (CBOE)
opened in April of 1973
call options on 16 common stocks
The widespread acceptance of exchange
traded options is commonly regarded as one
of the more significant and successful
investment innovations of the 1970s
Today we have option exchanges around the
world trading contracts on various financial
instruments and commodities
9
Options Contracts
Chicago Board of Trade
Chicago Mercantile Exchange
New York Mercantile Exchange
Montreal Exchange
Philadelphia exchange - currency options
London International Financial Futures
Exchange (LIFFE)
London Traded Options Market (LTOM)
Others- Australia, Switzerland, etc.
10
Swap Market - History
Similar theme to the evolution of the other
derivative products - swaps evolved in
response to an economic/financial
requirement in 1980s.







Instruments
Forwards
Futures
Options
Swaps
Instruments
Physical
Derivatives
OTC Exchange
Forward
Options
Swaps Future
Options
Spot Forwad



Derivatives
A financial instrument whose value is dependent upon or
derived from one or more basic variables. The derivative
itself is merely a contract between two or more parties.
Value is determined by fluctuations in the underlying
asset.
Often the variables underlying derivatives are the prices
of traded assets.
Are simply methods to manage ( hedge) risk.
Futures, forwards, swaps, options



Finite time horizon (i.e. fixed expiry date)

Requires at least two counterparties

Represent a zero-sum game between the
counterparties. That is, a gain to one side is a loss
to the other side.

The Payoff is based on the value of the underlying.
Derivative Key Characteristics
15
Uses of Derivatives
Risk management
Income generation
Financial engineering
16
Product Characteristics
Both options and futures contracts exist on a wide
variety of assets
Options trade on individual stocks, on market indexes, on
metals, interest rates, or on futures contracts
Futures contracts trade on agricultural commodities such as
wheat, live cattle, precious metals such as gold and silver
and energy such as crude oil, gas and heating oil, foreign
currencies, U.S. Treasury bonds, and stock market indexes
17
Product Characteristics
(contd)
The underlying asset is that which you
have the right to buy or sell (with options)
or to buy or deliver (with futures)

18
Product Characteristics
(contd)
Listed derivatives trade on an organized
exchange such as the Chicago Board
Options Exchange or the Chicago Board
of Trade, the NYMEX or the Montreal
Exchange

OTC derivatives are customized products
that trade off the exchange and are
individually negotiated between two
parties
19
Product Characteristics
(contd)
Options are securities and are regulated
by the Securities and Exchange
Commission (SEC) in the U.S and by the
Commission des Valeurs Mobilieres du
Quebec or the Commission Responsible
for Regulating Financial Markets in
Quebec for the Montreal Options
Exchange
Futures contracts are regulated by the
Commodity Futures Trading Commission
(CFTC) in the U.S and SIB in U.K.
Forward Contracts
Forward contract is a non-standardized contract
between two parties to buy or sell an asset at a
specified future time at a price agreed upon today.

Non-Standardized- It is custom made as per parties
involved.
Specified Future time- Any time in future when the delivery
is to be made.
Price Agreed upon Today- Price is mutually decided at the
time of entering into the contract.
Generally done in OTC market
How Forwards works..
Forward Contract
24/01/13
A agree to Buy 1000 bbl of Crude @ $120/bbl from B on 31
st
March ,13
OR
Cash Settlement (31/03/13)
$10000
$10000
Suppose Crude Price as on 31/03/13 is
$110/barrel(Loss to buyer)
Suppose Crude Price as on 31/03/13 is
$130/barrel(profit to buyer)
Physical Settlement (31/03/13)
$120K
1000 bbl oil
Example(Normal forward contract)
BP enters into a one month contract with its
customer to sell 1mmbtu of natural gas @
$5/mmbtu, to be delivered on 17th
February,2013.
If price in exchange is $7/mmbtu on.
Then there will be a loss of $2/mmbtu to BP
Example(Hedging)
BP now enters into a one month futures
contract with CME to buy 1mmbtu of natural
gas @ $5/mmbtu,to be delivered on 17th
February,2013.
If price in exchange is $7/mmbtu on .
Then there will be a profit of $2/mmbtu to
BP
Net effect=0

Futures
What is Futures Market?

A location where trading (buy-sell) in commodities is conducted in
accordance with specific rules, procedures, and guarantees.
FUTURES CONTRACTS
A contractual agreement to buy /sell a particular
commodity or financial instrument at a predetermined price in
the future.

Detail the quality and quantity of the underlying asset.
Standardized to facilitate trading on a futures exchange.
Some futures contracts may call for physical delivery of the asset,
while others are settled in cash.
No counter party Risk.
CME,ICE,MCX,NCDEX


Futures (Contd.)
Exchange
An Exchange is an institution, organization, or
association where stocks, bonds, options and
futures are traded.
Buyers and sellers come together to trade
during specific hours on business days .
Exchanges impose rules & regulations on the
firms and brokers that are involved with them .
If a particular commodity is traded on exchange,
it is referred to as listed.

Features Of Exchange
Platform for buyer & seller to transact with full
anonymity.
Standardized Contracts They are predefined
with Quantity, Quality, Delivery Month, Delivery
Location, Lot Size, etc (not flexible like the OTC
market)
Settlement Process, Pricing Methodology, etc
defined by the exchange
Exchange mitigates counterparty credit risk

Roles of Exchange
Anonymous auction platform
-price discovery by matching of demand-supply
Neutrality conflict of interest avoided.
Liquidity to participants
Standardized specifications- contract structure
Standard margining system

Role of Exchange
Risk management in a volatile market
Robust clearing & settlement systems
counter party credit risk absorbed
Fair, safe, orderly market rigorous financial
standards and surveillance procedures


Open Outcry system
A method of communicating on a stock,
commodity or futures exchange .
Involves verbal bids and offers as well as hand
signals to convey trading information in the
trading pits.
A contract is made when one trader cries out
that they want to sell at a certain price and
another trader responds that they will buy at that
same price.
Also called pit trading.
Example: NYMEX
Open Outcry
Continuous Price Discovery
If a trader is willing to pay the highest price
offered, he announces that to the other
traders, and all lower bids are silenced.
By exchange rules and by law, no one can
bid under a higher bid, and no one can offer
to sell higher than someone elses lower
offer.
Trade Execution & Recording
When a trade is executed, each selling broker
record transaction on a card indicating
commodity, quantity, delivery month, price,
brokers badge name and that of the buyer.
The pit card goes to PIT card locker within
one minute of a transaction.
PIT card locker time-stamps the card and
rushes to the data entry room

Trade Execution & Recording
Data entry operators key the data into the
exchange central computer system for the
Exchanges internal records. The card is then
scanned into the computer system, creating
an unalterable image as part of the archive.
Both buyers and sellers on the NYMEX
division also fill out trading cards which are
submitted to the Exchange at the end of the
day for dual audit trail that exists at any
exchange.
Identity of customers unknown
While each trader can see who the other floor
trader is, customers remain anonymous. In
fact, a customer who is seeking to take or
liquidate a large position may act through
several brokers so he does not tip his
competitors.
Both the Exchange and the Commodity
Futures Trading Commission(CFTC) are
aware of the identity of anyone holding a
substantial position.
Forwards vs Futures

Forwards Futures
Available to limited market
participants
Liquid market wider market
participation
Lengthy and time consuming
negotiations
Standardized contracts
Contract binding on both
parties
Positions can be squared off
Counter party credit risk Counter party risk assumed by
exchange
Contd..

Forwards Futures
Bilateral trades & negotiated
pricing
Transparent price discovery
mechanism
Inadequate dispute settlement
mechanism
Well defined dispute settlement
mechanism
Difficulty in reporting and
regulating various trades
The exchange is the central
reporting and regulating entity

Options
Options are traded both on exchanges and in the over-the-
counter market.
Two basic types of options.
A call option gives the holder the right to buy the underlying asset
by a certain date for a certain price.
A put option gives the holder the right to sell the underlying asset
by a certain date for a certain price.
The price in the contract is known as the exercise price or strike
price.
The date in the contract is known as the expiration date or
maturity.
American options can be exercised at any time up to the
expiration date.
European options can be exercised only on the expiration date.
Example
Mr A buys a European call option with a strike price
of $5/mmbtu to purchase 1mmbtu of Natural gas,
the expiration date of the option is in one month,
the premium price is $1/mmbtu.
If price in exchange is $8/mmbtu on the expiration
date.
Mr A will have an option whether to execute the
contract.
If he executes the contract there will be a profit of
$2/mmbtu.($8-$5-$1)
If he doesnt loss of $1(premium).

Example
Mr A bought an European put option with a strike
price of $5/mmbtu to sell 1mmbtu of Natural gas,
the expiration date of the option is in one month,
the premium price is $1/mmbtu.
If price in exchange is $8/mmbtu on the expiration
date.
Mr A will have an option whether to execute the
contract.
If he executes the contract there will be a loss of
$2($8-$5-$1).
In case he doesnt execute the contract there will
be loss of $1.


Options Basic Terminology
Call Option The right to buy a specified amount of commodity
at a specified rate

Put Option The right to sell .......

Premium The price of the option

Strike Price The rate at which the right can be exercised

Expiry Date The date on which the right can be exercised

Option holder Buys the option, has rights, has a long option position

Option writer (seller) Sells the option, has obligations, has a short
option position
Mechanics of options
Call Option

-- Buyer
Has the right to buy a futures contract at a predetermined price on or before a
defined date. Expectation: Rising prices

-- Seller
Grants right to buyer, so has obligation to sell futures at predeter- mined price
at buyer's discretion. Expectation: Neutral or falling prices

Put Option

-- Buyer
Has right to sell futures contract at a predetermined price on or before a
defined date. Expectation: Falling prices

-- Seller
Grants right to buyer, so has obligation to buy futures at a predetermined price
at buyer's discretion. Expectation: Neutral or rising prices

Swaps
Swap converts an unknown future price into current fixed price
A swap is a purely financial transaction designed to transfer price risk between the
swap purchaser and the swap provider.
Plain vanilla OTC agreement
Fixed for floating exchange of risk
Purely a financial transaction no delivery

Settlement:
If floating price lower than fixed (swap) price swap provider pays swap buyer
If floating price is higher than fixed (swap) price buyer pays seller/provider.

Example four month fix for Brent crude oil at $25.00 bbl:
Jan Feb March April
Floating price ($/bbl) 24.50 24.75 25.40 26.80
Quantity (bbls) 10,000 10,000 10,000 10,000
Actual cost $ 245,000 247,500 254,000 268,000
Swap seller pays 0 0 4,000 18,000
Swap buyer pays (5,000) (2,500) 0 0
Final cost to buyer 250,000 250,000 250,000 2,50,000

Cost to buyer $/bbl 25.00 25.00 25.00 25.00


Types of Traders
Hedgers-reduce their risk by taking an
opposite position in the market to what they
are trying to hedge.
Speculators- make bets or guesses on where
they believe the market is headed.
Arbitrageurs- Attempts to profit from price
inefficiencies in the market by making
simultaneous trades that offset each other
and capturing risk-free profits.



Example (Arbitrageurs)
Price in CME is $100/barrel.
Price in MCX is $101/barrel.
Cost of transportation from US to India is
$.5/barrel
In this case a traders will take long position in
US market and short position in Indian
Market thereby making a profit of $.5/barrel.
Henry Hub Natural Gas Futures: Contract Specification
Code NG
Venue CME ClearPort, CME Globex, Open Outcry (New York)
Hours
(All Times are
New York
Time/ET)
CME Globex: Sunday - Friday 6:00 p.m. - 5:15 p.m. New
York time/ET (5:00 p.m. - 4:15 p.m. Chicago Time/CT) with
a 45-minute break each day beginning at 5:15 p.m. (4:15
p.m. CT)

CME ClearPort: Sunday - Friday 6:00 p.m. - 5:15 p.m.
New York time/ET (5:00 p.m. - 4:15 p.m. Chicago Time/CT)
with a 45-minute break each day beginning at 5:15 p.m.
(4:15 p.m. CT)

Open Outcry: Monday Friday 9:00 a.m. 2:30 p.m.
(8:00 a.m. 1:30 p.m. CT)

Contract Unit

10,000 million British thermal units (mmBtu).
Code NG
Pricing Quotation U.S. dollars and cents per mmBtu.
Minimum Price
Increment
$0.001 (0.1) per mmBtu


Termination of Trading
Trading of any delivery month shall cease three (3)
business days prior to the first day of the delivery month.
In the event that the official Exchange holiday schedule
changes subsequent to the listing of a Natural Gas
futures, the originally listed expiration date shall remain
in effect. In the event that the originally listed expiration
day is declared a holiday, expiration will move to the
business day immediately prior.

Listed Contracts
The current year plus the next twelve years. A new
calendar year will be added following the termination of
trading in the December contract of the current year.
On CME Globex: The current year plus the next eight
years.
Henry Hub Natural Gas Futures: Contract Specification
Code NG
Settlement Type Physical
Grade and Quality
Specifications
Natural Gas meeting the specifications set forth
in the FERC-approved tariff of Sabine Pipe Line
Company as then in effect at the time of
delivery shall be deliverable in satisfaction of
futures contract delivery obligations.
Exchange Rule These contracts are listed with, and subject to,
the rules and regulations of NYMEX.
Henry Hub Natural Gas Futures: Contract Specification


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