Energy DerivativesSonal Gupta

Course plan (2 credits)Introduction to ExchangeWorking of ExchangeCommodity Exchange around the globeInstruments Types of traders

AgendaHistoryIntroduction to ExchangeOpen outcry systemInstrumentsTypes 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 - HistoryBy 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 (CBT)The Chicago Mercantile Exchange was established in 1919.

*Futures/Forward Contracts - History Contd1891 the Minneapolis Grain Exchange organized the first complete clearinghouse systemthe clearinghouse acts as the third party to all transactions on the exchangedesigned to ensure contract integritybuyers/sellers required to post margins with the clearinghousedaily settlement of open positions - became known as the mark-market system

*Futures/Forward Contracts - History ContdKey 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 contractsFinancial 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

*Option Contracts - HistoryChicago Board Options Exchange (CBOE) opened in April of 1973call options on 16 common stocksThe widespread acceptance of exchange traded options is commonly regarded as one of the more significant and successful investment innovations of the 1970sToday we have option exchanges around the world trading contracts on various financial instruments and commodities

*Options ContractsChicago Board of TradeChicago Mercantile ExchangeNew York Mercantile ExchangeMontreal ExchangePhiladelphia exchange - currency optionsLondon International Financial Futures Exchange (LIFFE)London Traded Options Market (LTOM) Others- Australia, Switzerland, etc.

*Swap Market - HistorySimilar theme to the evolution of the other derivative products - swaps evolved in response to an economic/financial requirement in 1980s.

InstrumentsForwardsFuturesOptionsSwaps

DerivativesAfinancial instrument whose value is dependent upon or derived fromone or more basic variables.The derivative itself is merely a contract between two or more parties. Value is determinedby fluctuationsin 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

*Uses of DerivativesRisk managementIncome generationFinancial engineering

*Product CharacteristicsBoth options and futures contracts exist on a wide variety of assetsOptions trade on individual stocks, on market indexes, on metals, interest rates, or on futures contractsFutures 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

*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)

*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

*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 ContractsForward contractis 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 Contract24/01/13A agree to Buy 1000 bbl of Crude @ $120/bbl from B on 31st March ,13 OR

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 BPNet 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 CONTRACTSA contractual agreement to buy /sell a particularcommodity or financial instrument at a predeterminedprice 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.)

ExchangeAn 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 ExchangePlatform 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 ExchangeAnonymous auction platform-price discovery by matching of demand-supplyNeutrality conflict of interest avoided.Liquidity to participantsStandardized specifications- contract structureStandard margining system

Role of ExchangeRisk management in a volatile market Robust clearing & settlement systems counter party credit risk absorbedFair, 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 thatthey want to sell at a certain price and another trader responds that they will buy at that same price. Also called pit trading. Example: NYMEXOpen Outcry

Continuous Price DiscoveryIf 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 & RecordingWhen 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 & RecordingData 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 unknownWhile 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

ForwardsFuturesAvailable to limited market participantsLiquid market wider market participationLengthy and time consuming negotiationsStandardized contractsContract binding on both partiesPositions can be squared offCounter party credit riskCounter party risk assumed by exchange

Contd..

ForwardsFuturesBilateral trades & negotiated pricingTransparent price discovery mechanismInadequate dispute settlement mechanismWell defined dispute settlement mechanismDifficulty in reporting and regulating various tradesThe exchange is the central reporting and regulating entity

OptionsOptions 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 OptionThe 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 PriceThe rate at which the right can be exercised

Expiry DateThe 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 optionsCall 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 priceA swap is a purely financial transaction designed to transfer price risk between the swap purchaser and the swap provider.Plain vanilla OTC agreementFixed for floating exchange of riskPurely a financial transaction no delivery

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

Example four month fix for Brent crude oil at $25.00 bbl: Jan Feb March AprilFloating price ($/bbl) 24.50 24.75 25.40 26.80Quantity (bbls) 10,000 10,000 10,000 10,000 Actual cost $245,000 247,500 254,000 268,000Swap seller pays 0 0 4,000 18,000 Swap buyer pays (5,000) (2,500) 0 0Final cost to buyer 250,000 250,000 250,000 2,50,000 Cost to buyer $/bbl 25.00 25.0025.00 25.00

Types of TradersHedgers-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 tradesthat offset each other andcapturing 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/barrelIn 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

CodeNGVenueCME 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 Unit10,000 million British thermal units (mmBtu).

Henry Hub Natural Gas Futures: Contract Specification

CodeNGPricing QuotationU.S. dollars and cents per mmBtu.Minimum Price Increment$0.001 (0.1) per mmBtu

Termination of TradingTrading 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 ContractsThe 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

CodeNGSettlement TypePhysicalGrade and Quality SpecificationsNatural 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 RuleThese contracts are listed with, and subject to, the rules and regulations of NYMEX.

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