introduction to etrm

8/21/2019 Introduction to ETRM

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Energy Derivatives

Sonal Gupta


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Agenda

History

Introduction to Exchange

Open outcry system Instruments

Types of Traders


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History

The first exchange for trading derivatives appearedto 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 ofMidwestern grain. These central marketplaces provideda place for buyers and sellerssuch as farmers andgrain dealersto meet, set quality and quantitystandards, and establish rules of business.


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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 rulesestablished by the Chicago Board of Trade(CBOT)

The Chicago Mercantile Exchange was

established in 1919.


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History Contd 1891 the Minneapolis Grain Exchange

organized the first complete clearinghousesystem

the clearinghouse acts as the third party to alltransactions on the exchange

designed to ensure contract integrity

buyers/sellers required to post margins with theclearinghouse

daily settlement of open positions - became known asthe mark-market system


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History Contd Key point is that commodity futures (evolving fromforward contracts) developed in response to aneconomic need by suppliers and users of various

agricultural goods initially and later othergoods/commodities - e.g metals and energycontracts

Financial futures - fixed income, stock index andcurrency futures markets were established in the70s and 80s - facilitated the sale of financialinstruments and risk (of price uncertainty) infinancial 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 exchangetraded options is commonly regarded as oneof 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


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Options Contracts Chicago Board of Trade

Chicago Mercantile Exchange

New York Mercantile Exchange Montreal Exchange

Philadelphia exchange - currency options

London International Financial FuturesExchange (LIFFE)

London Traded Options Market (LTOM)

Others- Australia, Switzerland, etc.


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Swap Market - History

Similar theme to the evolution of the otherderivative products - swaps evolved inresponse to an economic/financialrequirement in 1980s.


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Instruments

Forwards

Futures

Options Swaps


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Instruments

Physical Derivatives

OTC Exchange

Forward OptionsSwaps Future

Options

Spot Forwad


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Derivatives

A financial instrument whose value is dependent upon orderived from one or more basic variables. The derivativeitself is merely a contract between two or more parties.

Value is determined by fluctuations in the underlyingasset.

Often the variables underlying derivatives are the pricesof traded assets.

Are simply methods to manage ( hedge) risk. Futures, forwards, swaps, options


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

Requires at least two counterparties

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

to the other side.

The Payoff is based on the value of the underlying.

DerivativeKey Characteristics


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Uses of Derivatives

Risk management

Income generation

Financial engineering


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Product Characteristics

Both options and futures contracts exist on a widevariety of assets

Options trade on individual stocks, on market indexes, onmetals, interest rates, or on futures contracts

Futures contracts trade on agricultural commodities such aswheat, live cattle, precious metals such as gold and silverand energy such as crude oil, gas and heating oil, foreigncurrencies, U.S. Treasury bonds, and stock market indexes


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Product Characteristics(contd)

The under ly ing assetis that which youhave the right to buy or sell (with options)or to buy or deliver (with futures)


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Lis ted der ivativestrade on an organizedexchange such as the Chicago BoardOptions Exchange or the Chicago Board

of Trade, the NYMEX or the MontrealExchange

OTC derivat ivesare customized productsthat trade off the exchange and areindividually negotiated between twoparties


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Options are securities and are regulatedby the Securities and ExchangeCommission (SEC) in the U.S and by the

Commission des Valeurs Mobilieres duQuebec or the Commission Responsible

for Regulating Financial Markets in

Quebec for the Montreal OptionsExchange

Futures contracts are regulated by theCommodity Futures Trading CommissionCFTC in the U.S and SIB in U.K.


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Forward Contracts

Forward contract is a non-standardized contractbetween two parties to buy or sell an asset at aspecified future time at a price agreed upon today.

Non-Standardized- It is custom made as per partiesinvolved.Specified Future time- Any time in future when the deliveryis to be made.

Price Agreed upon Today- Price is mutually decided at thetime of entering into the contract.Generally done in OTC market


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How Forwards works..

Forward Contract

24/01/13

A agree to Buy 1000 bbl of Crude @ $120/bbl from B on 31stMarch ,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


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Example(Normal forward contract)

BPenters into a one month contract with its

customer to sell 1mmbtu of natural gas @

$5/mmbtu, to be delivered on 17thFebruary,2013.

If price in exchange is $7/mmbtu on.

Then there will be a loss of $2/mmbtu to BP


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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


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Futures

What is Futures Market?A location where trading (buy-sell) in commodities is conducted in

accordance with specific rules, procedures, and guarantees.


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FUTURES CONTRACTSA contractual agreement to buy /sell a particularcommodity or financial instrument at a predetermined price inthe 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.)


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Exchange

An Exchange is an institution, organization, orassociation where stocks, bonds, options andfutures are traded.

Buyers and sellers come together to tradeduring 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.


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Features Of Exchange

Platform for buyer & seller to transact with fullanonymity.

Standardized ContractsThey are predefined

with Quantity, Quality, Delivery Month, DeliveryLocation, Lot Size, etc (not flexible like the OTCmarket)

Settlement Process, Pricing Methodology, etcdefined by the exchange

Exchange mitigates counterparty credit risk


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Roles of Exchange

Anonymous auction platform

-price discovery by matching of demand-supply

Neutralityconflict of interest avoided.

Liquidity to participants

Standardized specifications- contract structure

Standard margining system


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Role of Exchange

Risk management in a volatile market

Robust clearing & settlement systemscounter party credit risk absorbed

Fair, safe, orderly marketrigorous financialstandards and surveillance procedures


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Open Outcry system


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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 thetrading pits.

A contract is made when one trader cries out

that they want to sell at a certain price andanother trader responds that they will buy at thatsame price.

Also called pit trading.

Example: NYMEX

Open Outcry


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Continuous Price Discovery

If a trader is willing to pay the highest priceoffered, he announces that to the othertraders, and all lower bids are silenced.

By exchange rules and by law, no one canbid under a higher bid, and no one can offerto sell higher than someone elses lower

offer.


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Trade Execution & Recording

When a trade is executed, each selling brokerrecord transaction on a card indicatingcommodity, quantity, delivery month, price,brokers badge name and that of the buyer.

The pit card goes to PIT card locker withinone minute of a transaction.

PIT card locker time-stamps the card andrushes to the data entry room


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Trade Execution & Recording

Data entry operators key the data into theexchange central computer system for theExchanges internal records. The card is then

scanned into the computer system, creatingan unalterable image as part of the archive.

Both buyers and sellers on the NYMEXdivision also fill out trading cards which are

submitted to the Exchange at the end of theday for dual audit trail that exists at anyexchange.


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Identity of customers unknown

While each trader can see who the other floortrader is, customers remain anonymous. Infact, a customer who is seeking to take or

liquidate a large position may act throughseveral brokers so he does not tip hiscompetitors.

Both the Exchange and the Commodity

Futures Trading Commission(CFTC) areaware of the identity of anyone holding asubstantial position.


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Forwards vs Futures

Forwards FuturesAvailable to limited market

participants

Liquid marketwider 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


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Contd..

Forwards FuturesBilateral 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


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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. Aput 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.


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Example

Mr A buys a European call option with a strike priceof $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).


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Example

Mr A bought an European put option with a strikeprice 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 willbe loss of $1.


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OptionsBasic Terminology

Call Option The right to buya specified amount of commodityat a specified rate

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

Premium The priceof the option

Strike Price The rateat which the right can be exercised

Expiry Date The dateon 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 shortoption position


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Mechanics of options

Call Option

-- Buyer

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

-- SellerGrants right to buyer, so has obligation to sell futures at predetermined priceat buyer's discretion. Expectation: Neutral or falling prices

Put Option

-- Buyer

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

-- Seller

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


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Swaps

Swap converts an unknown future price into current fixed price

A swap is a purely financial transaction designed to transfer price risk between theswap purchaser and the swap provider.

Plain vanilla OTC agreement Fixed for floating exchange of risk Purely a financial transactionno delivery

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

Examplefour 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


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Types of Traders

Hedgers-reduce their risk by taking anopposite position in the market to what theyare trying to hedge.

Speculators- make bets or guesses on wherethey believe the market is headed.

Arbitrageurs-Attempts to profit from price

inefficiencies in the market by makingsimultaneous trades that offset each otherand capturing risk-free profits.


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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 inUS market and short position in Indian

Market thereby making a profit of $.5/barrel.


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Henry Hub Natural Gas Futures: Contract Specification

Code NG

Venue CME ClearPort, CME Globex, Open Outcry (New York)

Hours(All Times areNew York

Time/ET)

CME Globex: Sunday - Friday 6:00 p.m. - 5:15 p.m. NewYork time/ET (5:00 p.m. - 4:15 p.m. Chicago Time/CT) witha 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: MondayFriday 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).


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Code NG

Pricing Quotation U.S. dollars and cents per mmBtu.

Minimum PriceIncrement

$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 schedulechanges subsequent to the listing of a Natural Gasfutures, the originally listed expiration date shall remainin effect. In the event that the originally listed expirationday is declared a holiday, expiration will move to the

business day immediately prior.

Listed ContractsThe current year plus the next twelve years. A newcalendar year will be added following the termination oftrading in the December contract of the current year.On CME Globex: The current year plus the next eightyears.



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Code NG

Settlement Type Physical

Grade and QualitySpecifications

Natural Gas meeting the specifications set forthin the FERC-approved tariff of Sabine Pipe Line

Company as then in effect at the time ofdelivery shall be deliverable in satisfaction offutures contract delivery obligations.

Exchange Rule These contracts are listed with, and subject to,the rules and regulations of NYMEX.



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