Energy derivative
Encyclopedia
Major players in energy derivatives include major trading houses, oil companies, utilities, financial institutions.
and options
, and over-the-counter (privately negotiated) derivatives such as forwards, swaps
and options.
The basic building blocks for all derivative contracts are the Futures and swaps contracts. For the energy market
s these are traded in New York NYMEX, in Tokyo TOCOM and on-line through IntercontinentalExchange
. A future is a contract to deliver or receive oil (in the case of an oil future) at a defined point in the future. The price is agreed on the date the deal/agreement/bargain is struck together with volume, duration, and contract index. The price for the futures contract at the date of delivery (contract expiry date) may be different. At the expiry date, depending upon the contract specification the 'futures' owner may either deliver/receive a physical amount of oil (this is a rare occurrence), they may settle in cash against an expiration price set by the exchange, or they may close out the contract prior to expiry and pay or receive the difference in the two prices. In futures markets you always trade with a formal exchange, every participant has the same counterpart.
A swap is an agreement whereby a floating price is exchanged for a fixed price over a specified period. It is a financial arrangement that involves no transfer of physical oil; both parties settle their contractual obligations by means of a transfer of cash. The agreement defines the volume, duration, fixed price, and reference index for the floating price (e.g., ICE Brent). Differences are settled in cash for specific periods usually monthly, but sometimes quarterly, semi-annually or annually. Swaps are also known as "contracts for differences" and as "fixed-for-floating" contracts - terms which summarize the essence of these financial arrangements. The amount of cash is determined as the difference between the price struck at the initiation of the swap and the settlement of the index. In a swap contract you trade with your counterpart (a company/institution/individual) and take risk on their capacity to pay you any amount that may be due at settlement. Thus one should carefully enter into a swap agreement with other party considering all these parameters.
That said, there are limitations to be considered when using energy derivatives to manage risk. A key consideration is that there is a limited range of derivatives available for trading. Continuing from the earlier example, if that company uses a specialised form of jet fuel, for which no derivatives are freely available, they may wish to create an approximate hedge, by buying derivatives based on the price of a similar fuel, or even crude oil. When these hedges are constructed, there is always the risk of unanticipated movement between the item actually being hedged (crude oil), and the source of risk the hedge is intended to minimise (the specialised jet fuel).
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Definition
An energy derivative is a derivative contract based on (derived from) an underlying energy asset, such as natural gas, crude oil, or electricity . Energy derivatives include exchange-traded contracts such as futuresFutures contract
In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...
and options
Option (finance)
In finance, an option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the...
, and over-the-counter (privately negotiated) derivatives such as forwards, swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
and options.
The basic building blocks for all derivative contracts are the Futures and swaps contracts. For the energy market
Energy market
Energy markets are those commodities markets that deal specifically with the trade and supply of energy. Energy market may refer to an electricity market, but can also refer to other sources of energy...
s these are traded in New York NYMEX, in Tokyo TOCOM and on-line through IntercontinentalExchange
IntercontinentalExchange
IntercontinentalExchange, Inc., known as ICE, is an American financial company that operates Internet-based marketplaces which trade futures and over-the-counter energy and commodity contracts as well as derivative financial products...
. A future is a contract to deliver or receive oil (in the case of an oil future) at a defined point in the future. The price is agreed on the date the deal/agreement/bargain is struck together with volume, duration, and contract index. The price for the futures contract at the date of delivery (contract expiry date) may be different. At the expiry date, depending upon the contract specification the 'futures' owner may either deliver/receive a physical amount of oil (this is a rare occurrence), they may settle in cash against an expiration price set by the exchange, or they may close out the contract prior to expiry and pay or receive the difference in the two prices. In futures markets you always trade with a formal exchange, every participant has the same counterpart.
A swap is an agreement whereby a floating price is exchanged for a fixed price over a specified period. It is a financial arrangement that involves no transfer of physical oil; both parties settle their contractual obligations by means of a transfer of cash. The agreement defines the volume, duration, fixed price, and reference index for the floating price (e.g., ICE Brent). Differences are settled in cash for specific periods usually monthly, but sometimes quarterly, semi-annually or annually. Swaps are also known as "contracts for differences" and as "fixed-for-floating" contracts - terms which summarize the essence of these financial arrangements. The amount of cash is determined as the difference between the price struck at the initiation of the swap and the settlement of the index. In a swap contract you trade with your counterpart (a company/institution/individual) and take risk on their capacity to pay you any amount that may be due at settlement. Thus one should carefully enter into a swap agreement with other party considering all these parameters.
History
The first energy derivatives covered petroleum products and emerged after the fundamental restructuring of the world petroleum market in the 1970s. at roughly the same time energy products began trading on derivatives exchange with crude oil, heating oil, and gasoline futures on NYMEX and gas oil and Brent crude on the International Petroleum Exchange (IPE).Applications
There are 3 principal applications for the energy derivative markets:- Risk Management ("Hedging")
- Speculation ("Trading")
- Investment Portfolio Diversification
Risk Management
This describes the process used by corporates, governments, and financial institutions to reduce their risk exposures to the movement of oil prices. The classic example provided by all text books is the activity of an airline company, jet fuel consumption represents up to 23% of all costs. The airline seeks to protect itself from rises in the jet fuel price in the future. In order to do this, it purchases a swap or a call option linked to the jet fuel market from an institution prepared to make prices in these instruments. Any subsequent rise in the jet price for the period is protected by the derivative transaction. A cash settlement at the expiry of the contract will fund the financial loss incurred by any rise in the physical jet fuel.That said, there are limitations to be considered when using energy derivatives to manage risk. A key consideration is that there is a limited range of derivatives available for trading. Continuing from the earlier example, if that company uses a specialised form of jet fuel, for which no derivatives are freely available, they may wish to create an approximate hedge, by buying derivatives based on the price of a similar fuel, or even crude oil. When these hedges are constructed, there is always the risk of unanticipated movement between the item actually being hedged (crude oil), and the source of risk the hedge is intended to minimise (the specialised jet fuel).
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