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.
Futures/Forward Contracts -
History
 By 1870’s 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 (CBT)
 The Chicago Mercantile Exchange was
established in 1919.

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 Futures/Forward Contracts -
History Cont’d
 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
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 Futures/Forward Contracts -
History Cont’d
 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
70’s and 80’s - facilitated the sale of financial
instruments and risk (of price uncertainty) in
financial markets

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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 1970’s
 Today we have option exchanges around the
world trading contracts on various financial
instruments and commodities 8
 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. 9
Swap Market - History
 Similar theme to the evolution of the other
derivative products - swaps evolved in
response to an economic/financial
requirement in 1980s.

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Instruments
 Forwards
 Futures
 Options
 Swaps
 Instruments

Physical Derivatives

OTC Exchange

Spot Forwad
Options

Forward Swaps Options Future

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
Derivative – Key Characteristics
 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.

Uses of Derivatives
 Risk management
 Income generation
 Financial engineering

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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

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Product Characteristics
(cont’d)
 The underlying asset is that which you
have the right to buy or sell (with options)
or to buy or deliver (with futures)

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Product Characteristics
(cont’d)
 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
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Product Characteristics
(cont’d)
 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 19

(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 31st March ,13

Cash Settlement (31/03/13)

Physical Settlement (31/03/13) OR
Suppose Crude Price as on 31/03/13 is
$110/barrel(Loss to buyer)
$120K
$10000
1000 bbl oil
$10000

Suppose Crude Price as on 31/03/13 is

$130/barrel(profit to buyer)
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 (Contd.)
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
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
Open Outcry
 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
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 else’s lower
offer.
Trade Execution & Recording
 When a trade is executed, each selling broker
record transaction on a card indicating
commodity, quantity, delivery month, price,
broker’s 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
Exchange’s 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
Available to limited market
participants
Lengthy and time consuming
negotiations
Contract binding on both
parties
Counter party credit risk
Futures
Liquid market –wider market
participation
Standardized contracts
Positions can be squared off
Counter party risk assumed by
exchange
Contd..
Forwards
Bilateral trades & negotiated
pricing
Inadequate dispute settlement
mechanism
Difficulty in reporting and
regulating various trades
Futures
Transparent price discovery
mechanism
Well defined dispute settlement
mechanism
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 doesn’t 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 doesn’t 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 CME Globex: Sunday - Friday 6:00 p.m. - 5:15 p.m. New
(All Times are York time/ET (5:00 p.m. - 4:15 p.m. Chicago Time/CT) with
New York a 45-minute break each day beginning at 5:15 p.m. (4:15
Time/ET) 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).

Henry Hub Natural Gas Futures: Contract Specification

Code NG
Pricing Quotation U.S. dollars and cents per mmBtu.
Minimum Price $0.001 (0.1¢) per mmBtu
Increment
Trading of any delivery month shall cease three (3)
business days prior to the first day of the delivery month.
Termination of Trading 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.
The current year plus the next twelve years. A new
Listed Contracts 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 Natural Gas meeting the specifications set forth
Specifications 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.
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