Financial/Energy Derivatives: futures

& options for risk management

Lecture 14
EFE/EFM
MS REE/MSESPM
26 Feb 2020

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Lecture notes
Based on
Prof. M. Spiegel & Prof. R. Stanton, U of Ca, Berkeley
Prof. A. Damodaran
Prof. Betty Simkins and Russell Simkins (editors), 2013.
Energy Finance and Economics. Analysis and Valuation,
Risk Management, and the Future of Energy. Kolb Series
Finance.
International Energy Markets by Carol Dahl, 2015.

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Energy derivatives
Thus, an energy financial derivative is a financial
instrument with a value based on some underlying
energy asset. Most energy derivatives are built from
four basic instruments:
 futures
forwards
options
swaps

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Energy Futures
An energy futures contract is an agreement to buy or
sell a specific energy asset at some future point in time.
The contract is purchased through an organized
exchange, with a standardized contract that can be
resold on the exchange. The contract specifies the
exact day that trading is closed and delivery is
required.

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An example in oil futures market
An important feature of futures market is the function
of “ marked to market” every day. Contract gains and
losses are settled at the end of each trading day and
the contract is rewritten at the closing futures price.
For example, suppose firm A buys crude oil futures at
$30/barrel for January xx11 delivery in Nov xx10 and
posted a margin of $3,375. Under this contract, A has
agreed to buy crude oil at $30 per barrel. Firm B sells
that contract for $ 30/barrel for Jan delivery and posts a
margin of $3,375 at the futures exchange.

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An example in oil futures market
Suppose then on the next day, the price of crude oil
delivery in Jan xx11 closes at $30.50 per barrel. Since A has
contracted to buy A at $ 30/barrel, it gains value for 1,000
barrels ie $ 500, whereas B loses $ 500. $500 gain will be
credited to A’s account and B’s account will be debited by
the same amount. If the margin account goes below the
daily minimum, then A or B has to level the position
otherwise the account will be liquidated. Such “marking
to margin” will decrease the default risk.
If A closes the contract on that day, A will have extra $ 500
as though A had purchased the crude oil at $ 30 per barrel.

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Trading on spot & forward markets
Spot market

St ST Gain or Loss ST -18

18 17 -1
18 18 0
18 19 1

Spot market & forward market FT = 18

Combined market
ST ST - St F - ST
T
effect
17 -1 1 0
18 0 0 0
19 1 -1 0
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Example of Call Option
Nepal Oil Corporation (NOC) needs 2 cargoes of
30,000 MT ( 1 MT equals 7.5 barrels) in November 2011.
It buys crude option (call option) at exercise price of
US$110/brl with US$1.5 premium. What will happen to
NOC’s finance, if (a) crude price in November goes to
US$ 120/brl and (b) US$ 100/brl?

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Example of Call Option
(a) In November, if bought at spot market
NOC’s cost of purchase =120*60,000*7.5 = $54 million
Call Option price =(110+1.5)*60,000*7.5 = $50.175 mill.
Saving = $ 3.83 mill
ie NOC pays crude purchase at $111.5/brl
(b) If bought at spot market
NOC’s cost of purchase = 100*60,000*7.5 =$45 mill
No exercise of call option,
so cost = $0.675 mill
NOC cost of crude purchase at $101.5/brl
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Assignment and readings
Chapter 33, Pandey, Page 713
From 1 to 3
Chapters 15, 16, 17, & 18, Energy Finance and
Economics, Page 332 to 390
Chapter 18 & 19. International Energy Markets.
Understanding pricing, policies and profits. Carol A.
Dahl, 2015. Please read these chapters thoroughly.

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