Oil Derivatives

8/2/2019 Oil Derivatives

1/91

Th e M ech a n i c s o f t h e

D er i v a t i v e s M a r k e t sWhat They Are and How They Function

April 2011

SPECI ALSUPPLEMENTto th e Ap r i l 2011 Oil Marke t Repor t


2/91

PREFACE

This supplement to the April 2011 OMR is designed as a reference document for member

governments and subscribers. It forms part of an ongoing work programme examining the

mechanicsofoilpriceformationandtheinteractionsbetweenthephysicalandpapermarkets.

Furtherresearchwillbeforthcoming intheOMR,theMTOGMand intheformofstandalone

papers in months to come. The work programme is being supported by contributions from

membergovernments,

most

notably

those

from

Japan

and

Germany.

We

are

grateful

for

that

support. Further impetus for this work comes from the joint work programme the IEA is

undertakingalongsidetheIEFandOPECsecretariats,asrequestedbyIEF,G8andG20Ministers.

TheworkisoverseenbyDavidFyfe,andthesupplementsmainauthorisBahattinBuyuksahin,

towhomallenquiriesshouldbeaddressed.


3/91

TABLE OF CONTENTS

1. INTRODUCTION TO DERIVATIVES ................................................................................................... 4

1.1 Basics of Derivatives ............................................................................................................................. 5

1.2 Types of Derivatives ............................................................................................................................. 6

1.3 History of Derivatives Markets .......................................................................................................... 6

1.4 The Markets ........................................................................................................................................... 7

1.5 Types of Market Participants in Derivatives Markets ................................................................... 8

1.5.1 Hedgers ............................................................................................................................................ 8

1.5.2 Speculators ...................................................................................................................................... 9

1.5.3 Swap Dealers and Commodity Index Traders ...................................................................... 10

2. FORWARDS AND FUTURES ................................................................................................................ 12

2.1 Forward Contracts ............................................................................................................................. 12

2.2 Futures ................................................................................................................................................... 14

2.2.1 Contract Specifications ............................................................................................................... 15

Box 1: Grade and Quality Specifications of WTI Contract ........................................................... 16

2.2.2 The Clearinghouse Margins ....................................................................................................... 17

2.2.3 Settlement Price, Volume and Open Interest in Futures Markets ................................... 192.2.4 Types of Orders ........................................................................................................................... 20

2.3 Hedging Using Futures Contracts ................................................................................................... 20

2.4 Basis Risk ............................................................................................................................................... 22

3. SWAPS ......................................................................................................................................................... 23

3.1 Mechanics of Swaps ............................................................................................................................ 26

4. OPTIONS .................................................................................................................................................... 284.1 Call Option ........................................................................................................................................... 29

4.2 Put Option ............................................................................................................................................ 32

4.3 Moneyness of Options ................................................................................................................... 33

4.4 Hedging Using Options ...................................................................................................................... 34

5. REFERENCES .............................................................................................................................................. 35

6. GLOSSARY OF THE DERIVATIVES MARKET TERMS....................................................................... 36


4/91

1. INTRODUCTIONTO DERIVATIVES INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

4 APRIL2011

1. INTRODUCTION TO DERIVATIVES

In the last thirtyyears, the world of financeand capitalmarkets hasexperienceda quite spectacular

transformation in the derivatives markets. Futures, options and swaps, as well as other structured

financial products, are now actively traded on many exchanges and overthecounter (OTC) markets

throughout the world, notonly by professional traders but also by retail investors, whose interest in

thesederivativeshasincreased.

Derivatives are financial instruments whose returns are derived from those of another financial

instrument.Asopposedtospot(cash)markets,wherethesaleismade,thepaymentisremitted,andthe

goodorsecurity isdelivered immediatelyorshortlythereafter,derivativesaremarkets forcontractual

instruments whose performance depends on the performance of another instrument, the socalled

underlyinginstrument.Forexample,acrudeoilfuturesisaderivativewhosevaluedependsontheprice

ofcrudeoil.

Derivatives contracts play a very important role in managing the risk of underlying securities such as

commodities, bonds, equities and equity indices, currencies, interest rates or liability positions.

Commodityderivativesaretradedinagriculturalproducts(corn,wheat,soybeans,soybeanoil),livestock

(livecattle,

pork

bellies,

lean

hogs);

precious

metals

(gold,

silver,

platinum,

palladium);

industrial

metals

(copper, zinc, aluminum, tin, nickel); soft commodities (cotton, sugar, coffee, cocoa); forest products

(lumberandpulp);andenergyproducts(crudeoil,naturalgas,gasoline,heatingoil,electricity).Financial

derivatives,whereinmanycasesnodeliveryofthephysicalsecurityisinvolved,aretradedonstocksand

stock indices (single stocks, S&P 500, Dow Jones Industrials); government bonds (US Treasury bonds,

USTreasury notes); interest rates (EuroDollars) and foreign exchanges (Euro, JapaneseYen,

CanadianDollar). In recentyears,newderivatives instrumentshavebeendevised,whicharedifferent

from the more traditional instruments, as the underlying asset of these derivatives is no longer

necessarily a liquid, marketable good. For example, derivatives trading has begun on weather and

creditrisk.

Thederivativesmarketasawhole,andoverthecountermarkets inparticular,has recentlyattracted

moreattention after theonsetof the financial crisis in 2008. In this report,we will lookat themain

buildingblocksofderivativesmarkets,includingforwards,futures,swapsandoptionsmarkets.


5/91

INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS 1. INTRODUCTIONTO DERIVATIVES

APRIL 2011 5

1.1 Basics of Derivatives

Derivativescontractsgettheirnamefromthefactthattheyarederivedfromsomeotherunderlying

claim, contract, or asset. For instance, a crude oil forward contract is derived from the underlying

physicalassetcrudeoil.Derivativesarealsocalledcontingentclaims.Thistermreflectsthefactthat

theirpayoffthecashflowiscontingentuponthepriceofsomethingelse.Goingbacktothecrudeoil

forward contract example, the payoff to a crude oil forward contract is contingentupon the price of

crudeoilattheexpirationofthecontract.

Hedgers,speculatorsandarbitrageursusederivatives instruments fordifferentpurposes.Hedgersuse

derivativestoeliminateuncertaintybytransferringtherisktheyfacefrompotentialfuturemovementin

pricesoftheunderlyingasset.Inthisregard,derivativesserveasaninsuranceorriskmanagementtool

againstunforeseenpricemovements.Speculators,on theotherhand,use these instruments tomake

profitsbybettingonthefuturedirectionofmarketpricesoftheunderlyingasset.Therefore,derivatives

canbeusedasanalternativetoinvestingdirectlyintheassetwithoutbuyingandholdingtheassetitself.

Arbitrageursusederivativestotakeoffsettingpositionsintwoormoreinstrumentstolockinaprofit.

Inadditiontoriskmanagement,derivativesmarketsplayaveryusefuleconomicroleinpricediscovery.

Pricediscovery is theprocessofwhichmarketparticipants (buyersandsellers)uncoveranassets full

information

or

permanent

value,

and

then

disseminate

those

prices

as

information

throughout

the

marketandtheeconomyasawhole.Thus,marketpricesare importantnotonlyforthosebuyingand

selling theassetorcommoditybutalso for the restof theglobalmarketsparticipants (consumersor

producers)whoareaffectedbythepricelevel.

Insummary,twoofthemostimportantfunctionsofderivativesmarketsarethetransferofriskandprice

discovery.Inawellfunctioningfuturesmarket,hedgers,whoaretryingtoreducetheirexposuretoprice

risk,

will

trade

with

someone,

generally

a

speculator,

who

is

willing

to

accept

that

risk

by

taking

opposing

positions.Bytakingtheopposingpositions,thesetradersfacilitatetheneedsofhedgerstomitigatetheir

pricerisk,whilealsoaddingtooveralltradingvolume,whichcontributestotheformationof liquidand

wellfunctioningmarkets.


6/91


6 APRIL2011

1.2 Types of Derivatives

There are four major types of derivatives instruments. In some respects, these may be regarded as

buildingblocksandcanbecategorisedasfollows:

Forwards

Futures

Swaps

Options

Each instrument has its own characteristics, which offers advantages in using them, but also brings

disadvantages,whicharediscussedlaterinthetext.

1.3 History of Derivatives Markets

Althoughderivativesarefrequentlyconsideredtobesomethingnewandexotic,theyhavebeenaround

formillennia.Thereareexamplesofderivative contracts inAristotlesworksand theBible. It is true,

however,thattheuseoffinancialderivativeshasbeengrowingsince1980s.

Theoriginsofderivativestradingdatesbackto2000B.C.whenmerchants,inwhatisnowcalledBahrain

intheMiddleEast,madeconsignmenttransactionsforgoodstobesold in India.

Derivativescontracts,

datingback to the same era,havealsobeen foundwrittenon clay tablets fromMesopotamia,when

farmersborrowed

barley

from

the

Kings

daughter

by

promising

to

return

itat

harvest

time.

This

trade

caneitherbe consideredasa commodity loanorasa shortsellingoperation. It isa commodity loan

becausefarmersborrowedbarleyinordertouseitforplantingthecropandtheypromisedtoreturnit

afterharvesting.Ofcourse,itisashortsellingtradesincefarmersdonothaveanybarleyatthetimeof

contractagreement.1

A more literary reference comes some 2350 years ago from Aristotle, who discussed a case of

manipulationcall

option

style

investment

on

olive

oil

presses.

In

Politics,

Aristotle

told

the

story

of

a

trader,whobuysexclusiverighttouseoliveoilpressesintheupcomingharvestfromtheownersofthis

equipment. The trader paid some down payment for this right. During the harvesting season, the

demandforoliveoilpressesroseaspredictedbythetraderandhesoldhisrighttousethisequipment

to other parties. In the meantime, the trader made a profit without actually being in the olive oil

productionbusiness.The traderstradecarriedonlyhisdownpayment (optionpremium)asarisk;on

theotherhand,ownersofoliveoilpressestransferredsomeoftherisksassociatedwiththepossibilityof

abadcropseasontothetrader.

1SeeWeber(2008)foradetailedexcellentreviewofthehistoryofderivativesmarkets.


7/91


APRIL 2011 7

Derivativestrading inanexchangeenvironmentandwithtradingrulescanbetracedbacktoVenice in

the12th

century.

Forwardandoptionscontractsweretradedoncommodities,shipmentsandsecurities

inAmsterdamafter1595.

ThefirststandardisedfuturescontractcanbetracedtotheYodoyaricemarket

inOsoka,Japanaround1700. IntheUS,forwardandfuturescontractsofagriculturalproductssuchas

wheatandcornhavebeenformallytradedontheChicagoBoardofTrade2(CBOT)since1848.TheCBOT

initially offered forward contracts on agricultural commodities. In 1865, the first standardised futures

contractswereintroducedontheCBOTfloor.TheChicagoMercantileExchange(CME)wasestablishedin

1919 to offer futures contracts on livestocks and agricultural products. The CME has increased the

number of contracts listings over time and is now best known worldwide for its financial products,

includingitsflagshipEurodollarcontract.

1.4 The MarketsTherearebasicallytwotypesofmarketsinwhichderivativescontractstrade.Theseareexchangetraded

markets and overthecounter (OTC) markets. Regulated exchanges, since their inception in the

mid1800suntilrecently,havebeenthemainvenueonwhichproducersand largescaleconsumersof

commoditieshedge their riskagainstfluctuations inmarketprices,whileallowingspeculatorstomake

profitsbyanticipating these fluctuations.Exchangetradedderivativesare fully standardisedand their

contracttermsaredesignedbyderivativesexchanges.

However,duetostandardisationandfixedcontractspecificationsinexchangetradedcontracts,financial

institutions began to develop nonexchangetraded (or overthecounter, OTC) derivatives contracts.

InstrumentsintheOTCmarketsaregenerallyprivatelynegotiatedbetweenmarketmakers(orsocalled

swapdealers)andtheirclients.Unlikeexchangetradedproducts,OTCinstrumentscanbecustomisedto

fit clients needs. These instruments, like standardised futures contracts, can be used by hedgers to

hedgetheirexposuretothephysicalassetitself,orbyspeculatorstomakespeculativeprofitsifpricesof

theunderlyingassetmoveinanexpecteddirection.

AccordingtothelatestBankofInternationalSettlements(BIS)survey,thetotalnotionalvalueofallOTC

derivatives reached $583trillion at endJune2010, of which $2.85trillion (0.5%) was in commodity

related derivatives. At their peak in endJune2008, the total notional value of commodityrelated

derivativeshadreached$13trillion,or2%ofthetotalmarket.Thetotalnotionalvalueofallexchange

tradedderivativescontractsexceeded$90trillionatthattime.

2CBOTmergedwithCMEin2007.


8/91


8 APRIL2011

Figure1:SizeofOvertheCounterandExchangeTradedDerivativesMarkets

1.5 Types of Market Participants in Derivatives MarketsTradingparticipants inderivativesmarketscanbeplaced into threebasiccategoriesaswementioned

earlier:(1)hedgers(2)speculatorsand(3)arbitrageurs.Inadditiontothesethreebroadcategories,swap

dealers and commodity index traders are important types of market participants and have been

centrestage during the recent debate on financial regulations. We discuss swap dealers and their

businessindetailsinSection3.

1.5.1 Hedgers

Hedgers use derivatives markets to offset the risk of prices moving unfavourably for their ongoing

business activities. Hedgers, including both producers (oil producers, farmers, refiners, etc) and

consumers(airlines,refiners,etc),holdpositionsinboththeunderlyingcommodityandinthefutures(or

options) contracts on that commodity. A long futures hedge is appropriate when you know you will

purchaseanassetinthefutureandwanttolockintheprice.Ashortfutureshedgeisappropriatewhen

youknowyouwillsellanassetinthefutureandwanttolockintheprice.Byhedgingawayrisksthatyou

donotwanttotake,youcantakeonmorerisksthatyouwanttotakewhilemaintainingdesired/target

aggregaterisk

levels.

Forexample,anoilproducercanhedgeagainstdeclinesinoilpricebysellinganoilfuturescontract(taking

ashortposition)ontheexchangeinlightofitsoilposition,whichisnaturallylong,inthephysicalmarket.If

thepriceofoilincreasesovertime,theprofitsfromtheactualsaleofoilareoffsetbylossesfromholding

the futurescontract.Ontheotherhand, ifpricesdeclineover time,oilproducerscanoffset their losses

from the actual sale of oil from selling their short position in the futures market. Basically, whatever

happenstoprices,hedgersareguaranteedtohaveconstantprofit.

0

100

200

300

400500

600

700

800

SizeofMarkets($trillion)

OTC

Exchange


9/91


APRIL 2011 9

Hedgers,whoholdshortpositionsinthephysicalmarket,takelongpositionsinthepapermarkettolimit

the risk associated with fluctuations in underlying asset prices. For example, an airline company can

hedgeagainstariseinoilpricesbybuyingoilfuturescontracts(takingalongposition)ontheexchange

for the oil required to operate its business activities (the airline company position is short in the

physicalmarket).

Some hedgers might be both producers and consumers in some related commodities. For example,

refinersusecrudeoiltoproducepetroleumproducts.Crudeoil isrefinedtomakepetroleumproducts,

inparticularheatingoilandgasoline.Thesplitofoilintoitsdifferentcomponentsisfrequentlyachieved

by a process known as cracking, hence the difference in price between crude oil and equivalent

amountsofheatingoilandgasoline is calleda crack spread. Therefore, refiners can takepositions in

crackspreads.

3

1.5.2 Speculators

Speculators, on the other hand, use derivatives to seek profits by betting on the future direction of

marketpricesof theunderlyingasset.Hedge funds, financial institutions,commodity tradingadvisors,

commodity pool operators, associate brokers, introducing brokers, floor brokers and traders are all

considered to be speculators. In the CFTCs Commitment of Traders report, hedge funds, commodity

pooloperators,commoditytradingadvisorsandassociatepersonsconstitutemanagedmoneytraders.

Speculators use derivatives instruments to make profits by betting on the future direction of market

prices of the underlying asset. Traditional speculators can be differentiated based upon the time

horizonsduringwhichtheyoperate.Scalpers,ormarketmakers,operateattheshortesttimehorizon

sometimestradingwithinasinglesecond.Thesetraderstypicallydonottradewithaviewastowhere

pricesaregoing,butrather makemarketsbystandingreadytobuyorsellatamomentsnotice.The

goalofamarketmakeristobuycontractsataslightlylowerpricethanthecurrentmarketpriceandsell

3 The following discussion of crack spread contracts comes from the Energy Information Administration publication Derivatives and Risk

ManagementinthePetroleum, NaturalGas,andElectricityIndustries.

Refiners profits are tied directly to the spread, or difference, between the price of crude oil and the prices of refined products. Because

refinerscanreliablypredicttheircostsotherthancrudeoil,thespread istheirmajoruncertainty.Oneway inwhicharefinercouldensurea

givenspreadwouldbetobuycrudeoilfuturesandsellproduct futures.Anotherwouldbe tobuycrudeoilcalloptionsandsellproductput

options.Bothofthosestrategiesarecomplex,however,andtheyrequirethehedgertotieupfundsinmarginaccounts.Toeasethisburden,

NYMEXin1994launchedthecrackspreadcontract.NYMEXtreatscrackspreadpurchasesorsalesofmultiplefuturesasasingletradeforthe

purposesofestablishingmarginrequirements.Thecrackspreadcontracthelpsrefinerstolockinacrudeoilpriceandheatingoilandunleaded

gasolinepricessimultaneously inordertoestablishafixedrefiningmargin.Onetypeofcrackspreadcontractbundlesthepurchaseofthree

crude oil futures (30000 barrels) with the sale a month later of two unleaded gasoline futures (20000 barrels) and one heating oil future

(10000barrels).The321ratioapproximatestherealworldratioofrefineryoutput2barrelsofunleadedgasolineand1barrelofheatingoil

from3barrelsofcrudeoil.Buyersandsellersconcernthemselvesonlywiththemarginrequirementsforthecrackspreadcontract.Theydonot

dealwithindividualmarginsfortheunderlyingtrades.Anaverage321ratiobasedonsweetcrudeisnotappropriateforallrefiners,however,

andtheOTCmarketprovidescontractsthatbetterreflectthesituationof individualrefineries.Somerefineriesspecialize inheavycrudeoils,

whileothers

specialize

in

gasoline.

One

thing

OTC

traders

can

attempt

isto

aggregate

individual

refineries

so

that

the

traders

portfolio

isclose

to the exchange ratios. Traders can also devise swaps that are based on the differences between their clients situations and the

exchangestandards.


10/91


10 APRIL2011

themataslightlyhigherprice,perhapsatonlyafractionofacentprofitoneachcontract.Skilledmarket

makers can profitby trading hundredsoreven thousandsof contractsaday.Marketmakersprovide

immediacytothemarket.Withoutamarketmaker,anothermarketparticipantwouldlikelyhavetowait

longeruntilthearrivalofacounterpartywithanoppositetradinginterest.

Other types of speculators take longerterm positions based on their view of where prices may be

headed.Daytradersestablishpositionsbasedontheirviewsofwherepricesmightbemovingwithin

minutesorhours,whiletrend followers takepositionsbasedonpriceexpectationsoveraperiodof

days, weeks or months. These speculators can also provide liquidity to hedgers in futures markets.

Through their efforts to gather information on underlying commodities, the activity of these traders

servesto

bring

information

to

the

markets

and

aid

in

price

discovery.

1.5.3 Swap Dealers and Commodity Index Traders

InstrumentsintheOTCmarketsaregenerallyprivatelynegotiatedbetweenmarketmakers(orsocalled

swap dealers) and their client. The party offering the swap, or swap dealer, takes on any price risks

associated with the swap and thus must manage the risk of the commodity exposure. The counter

partiestoswapdealersaregenerallyhedgers,speculatorsorcommodityindextraders.

Investor interest in commodities, including oil, has risen quite dramatically over the last decade and

commoditieshavebecomeanewassetclassininstitutionalinvestorsportfolio.Partly,thisdevelopment

is due to diversification benefits. In addition, the development of new investment vehicles, such as

exchangetraded funds,hasallowed individual investors togetexposure tomovements incommodity

prices.Duetothestorageandtradingcostsassociatedwithdirectphysical investment incommodities,

themainvehicleusedbyinvestorstogainexposuretocommoditiesisviacommodityindices(basketsof

shortmaturity commodity futures contracts that are periodically rolled as they approach expiry),

exchangetraded funds or other structured products. These instruments provide generally longonly

exposuretocommodities.Thevastmajorityofcommodity indextradingbyprincipals isconductedoff

exchangeusingswapcontracts.

The main goal of commodity index funds is to track the movement of commodity prices. There exist

severalmajorcommodityindicesaswellassubindices.StandardandPoorsGSCI(formerlytheGoldman

SachsCommodityIndex) istheoldestandmostwidelytracked index inthemarket.TheS&PGCSI,first


11/91


APRIL 2011 11

created in1991,covers24commoditiesbut isheavilytiltedtowardenergybecause itsweightsreflect

worldproductionfigures.Forexample,in2010,energymarketsreceivedalmost72%weight.

Investorsareexposedtothreesourcesofreturnsintotalreturncommodityindexinvestments.Thefirst

type is the yield on the underlying commodity futures. The second type is the roll return, which is

generated from the rollingofnearby futures into firstdeferred contracts.Dependingonwhether the

forward curve is in contango (when longerdated futures prices are higher thannearby contracts)or,

conversely, inbackwardation(whennearbypricesarehigherthan longerdatedfuturesprices),theroll

yield iseithernegative (incontango)orpositive (inbackwardation).Thethird type istheTbill return,

which is the returnoncollateral.Historically, the roll returnhasconstituted the largestcontributor in

totalreturn.However,therollreturncomponenthasbeennegativesince2005fortheS&PGSCITotal

ReturnIndex

due

to

the

contango

market

we

observe

in

crude

oil

futures

markets.

Institutional investorsgenerallygainexposuretocommoditypricesthroughtheir investment ina fund

that tracks a popular commodity index. The fund managers themselves either directly offset their

resultingshortpositionsbygoing long infuturesmarketsorbyenteringswapagreementswithaswap

dealer.Inturn,swapdealersintheOTCmarketgenerallygolongorshortinthefuturesmarkettooffset

their net long (or short) position. Of course, the client base of swap dealers also includes

traditional

hedgers.


12/91

2. FORWARDSAND FUTURES INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

12 APRIL2011

2. FORWARDS AND FUTURES

2.1 Forward Contracts

AforwardcontractisanOTCagreementbetweentwopartiestoexchangeanunderlyingasset:

foranagreeduponprice(theforwardpriceorthedeliveryprice)

atagivenpointintimeinthefuture(theexpirydateormaturitydate)

Since it is tradedbetween twoparties in theoverthecountermarket, there isasmallpossibilitythat

eithersidecandefaultonthecontract.Therefore,forwardcontractsaremainlybetweenbiginstitutions

or between a financial institution and one of their clients. Forward contracts are most popular in

currencyandinterestratesmarkets.

Theparty

that

has

agreed

to

buy

the

underlying

asset

has

along

position.

The

party

that

has

agreed

to

sell the underlying asset has a short position. By signing a forward contract, one can lock in a price

exante forbuyingor sellinga security.Expost,whetheronegainsor loses from signing the contract

dependsonthespotpriceatexpiry.Ifthepriceoftheunderlyingassetrises,thenthepartywhohasa

longpositioninthecontractgainswhilethepartywhohasashortpositionloses.

Example1: Acommoditycontract

TraderAagrees

to

sell

to

Trader

Bone

million

barrels

of

WTI

crude

oil

at

the

price

of

$100/bbl

withdeliveryinsixmonths.Inthisforwardcontract,WTIcrudeoilistheunderlyingasset.Trader

Aissaidtobeshortthecontract,sincehemustdeliveroilinsixmonths.TraderB issaidtobe

longthecontract,sincehereceivesthedeliveryofoilinsixmonths.

Ifattheendofsixmonthsthepriceofoilisat$110,thenthetraderwithalongpositionhasa

profitof$10000000andthetraderwithashortpositionloses$10000000.Ontheotherhand,

if the price of oil is $95 at the end of six months, then the trader with a long position loses

$5000000andtheonewithashortpositionhasaprofitof$5000000.

Example2: Aforeignexchangecontract

On 18 February 2011, Party A signs a forward contract with Party B to sell one million

Britishpounds(GBP)at$1.6190perGBPsixmonthslater.

Today(18February2011),signacontract,shakehands.Nomoneychangeshands.

PartyAenteredashortpositionandPartyBenteredalongpositiononGBP.


13/91

INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS 2. FORWARDSAND FUTURES

APRIL 2011 13

Butsinceitisonexchangerates,wecanalsosay:PartyAenteredalongposition

andPartyBenteredashortpositiononUSD.

18August2011(theexpirydate),PartyApaysonemillionGBPtoPartyB,and

receives1.6190millionUSDfromPartyBinreturn.

Currently(18February,thespotpriceforthepound(thespotexchangerate)is

1.6234.Sixmonths later (18August2011), theexchange rate canbeanything

(unknown).

$1.6190perGBPistheforwardprice.

Theforwardpriceforacontractisthedeliverypricethatwouldbeapplicabletothecontractifit

werenegotiatedtoday.Itisthedeliverypricethatwouldmakethecontractworthexactlyzero.

Inthepreviousexample,PartyAagreestosellonemillionpoundsat$1.6190perGBPatexpiry.

Ifthespotpriceis$1.61atexpiry,whatistheprofitandloss(P&L)forpartyA?

On18August2011,PartyAcanbuyonemillionGBPfromthemarketatthespot

priceof$1.61andsellittoPartyBperforwardcontractagreementat$1.6190.

ThenetP&Latexpiryisthedifferencebetweenthestrikeprice(K=1.6190)and

thespotprice(ST=1.61),multipliedbythenotionalvalue(onemillion).Hence,

the

profit

is

$9

000.

The primary use of a forward contract is to lock in the price at which one buys or sells a

particulargoodinthefuture.Thisimpliesthatthecontractcanbeutilisedtomanagepricerisk.

Forward contracts can be used to hedge against unforeseen movement in market prices.

Consideranairlinecompanywhich isgoing tobuy100000barrelsofoiloneyear fromtoday.

Supposethatforwardpricefordeliveryinoneyearis$100/bbl.Supposethattheyieldonaone

yearandzerocouponbondis5%.Theairlinecompanycanuseaforwardcontracttoguarantee

thecostofbuyingoilforthenextyear.Thepresentvalueofthiscostwillbe100/1.05=95.24.The

airlinecompanycould invest thisamount tobuyoil inoneyearor itcouldpayanoil supplier

$100 at the delivery of the oil. If the spot price at the end of one year is above the agreed

forwardprice,theairlinecompanygainsfromthishedging.Ifthespotpriceatmaturityisbelow

theforwardprice,itwouldleadtotheairlinecompanytopaymorethanthemarketpriceofoil.

Regardlessof thespotpriceat thedelivery, theairlinecompanyprotects itself frompotential

lossandeliminatesuncertaintyregardingpricemovements.


14/91


14 APRIL2011

2.2 Futures

Likeaforwardcontract,afuturescontractisabindingagreementbetweenasellerandabuyertomake

(seller)andtotake(buyer)deliveryoftheunderlyingcommodity(orfinancialinstrument)ataspecified

futuredatewithagreeduponpaymentterms.Unlikeforwardcontracts:

Futurescontractsarestandardisedandexchangetraded.

Defaultriskisbornebytheexchangeclearinghouse.

Tradersareallowedtoreverse(offset)theirpositions,sothatphysicaldeliveryisrare(futures

canbeusedtotradeintherisk,notthecommodity).Thisistruebecausemosthedgersarenot

dealing in the commodity deliverable against the futures contract. For instance, an airline

companyisnotgoingtouseWTIcrudeoilinCushing,Oklohama,foritsoperation,butmayuse

the WTI futures contract as a hedge. That is, most hedgers are cross hedgers. Similarly,

speculatorsare

just

betting

on

price

movement,

and

have

no

interest

in

owning

the

physical

oil.

Therefore,mosthedgersandspeculatorsreversetheirpositionpriortodelivery.

Valueismarkedtomarketdaily.

Differentexecutiondetailsalso leadtopricingdifferences,e.g.,effectofmarkingtomarketon

interestcalculation.

Table2.1:ComparisonBetweenForwardandFuturesContracts

FORWARDS

FUTURES

Privatecontractsbetweentwoparties Exchangetraded

Nonstandardcontract Standardcontract

Usuallyonespecifieddeliverydate Rangeofdeliverydates

Settledattheendofthecontract Settleddaily

Deliveryorfinalcashsettlementusuallyoccurs Delivery is rare, usually parties offset their

positionbeforematurity

Somecreditrisk Virtuallynocreditrisk

Thefactthatfuturescontractstermsarestandardised is importantbecause itenablestraderstofocus

their attention on one variable, namely price. Standardisation also makes it possible for traders

anywhereintheworldtotradeinthesemarketsandknowexactlywhattheyaretrading.Thisisinsharp

contrast to thecash forwardcontractmarket, inwhichchanges inspecifications fromonecontract to

anothermightcausepricechangesfromonetransactiontoanother.


15/91


APRIL 2011 15

2.2.1 Contract Specifications

Oneof themaindifferencesbetween forwardcontractsand futures contracts is the fact that futures

contractsarestandardised.Whenanexchangeintroducesanewcontract,ithastospecifyinsomedetail

the exact nature of the asset, the contract size, delivery point, delivery time, and settlement type

(physicaldeliveryorcashsettlement).

Theunderlyingassetinthefuturescontractcanbeanything,rangingfromcommoditiestostockindices,

equities, bond, foreignexchange, interest rate,and so on. However, theexchange has to specify the

exact terms in identifying the contract. The financial assets in futures contracts are well defined and

thereisnoambiguity.However,inthecaseofcommodities,theremaybequiteavariationinthequality

ofwhatisavailableinthemarketplace.Whentheassetisspecified,theexchangehastospecifyindetail

grade

or

grades

of

commodity

that

are

acceptable

for

delivery.

For

example,

the

Chicago

Mercantile

Exchange(CME)deliverablegradespecificationoftheWTIfuturescontractispresentedinBox1.

Standardisationoffuturescontractsalsorequiresthespecificationofthedeliverypointandthecontract

size(amountofassetthathastobedeliveredunderonecontract).Forexample,undertheWTIfutures

contractstradedontheCME,deliverycanbemadeF.O.B.atanypipelineorstoragefacilityinCushing,

Oklahoma with pipelineaccess to TEPPCO, Cushing storage or Equilon Pipeline Company LLC Cushing

storage.Thecontractsize,ontheotherhand,is1000USbarrels(42000USgallons)ofWTIcrudeoil.

Futurescontractsarealsostandardisedwithrespecttothedeliverymonth.Theexchangemustspecify

the precise period during the month when delivery can be made. The exchange also specifies when

trading inaparticularmonths contractwillbegin, the lastdayonwhich trading can takeplace fora

givencontractaswellas thedeliverymonths.Forexample,CMEWTIcrudeoil futuresare listednine

yearsforwardusingthefollowinglistingschedule:consecutivemonthsarelistedforthecurrentyearand

thenextfiveyears;inaddition,theJuneandDecembercontractmonthsarelistedbeyondthesixthyear.

Additional months will be added on an annual basis after the December contract expires, so that an

additionalJuneandDecembercontractwouldbeaddednineyearsforward,andtheconsecutivemonths

inthesixthcalendaryearwouldbefilledin.

Even though physical delivery does not occur on most contracts, delivery is important nonetheless.

Delivery ties the price of the expiring futures to the price of the physical commodity at delivery.

Nonetheless, cash settlement can be considered another way to tie the futures and cash markets

together. Inacashsettledcontract,atexpirationthebuyerpaysthesellerthedifferencebetweenthe

fixed

price

established

in

the

contract

and

the

reference

price

prevailing

on

payment.


16/91


16 APRIL2011

Box 1: Grade and Quality Specifications of WTI Contract (Source CME)

Light sweet crude oil meeting all of the following specifications and designations shall be

deliverableinsatisfactionoffuturescontractdeliveryobligationsunderthisrule:

(A)

Domestic

Crudes,

(Deliverable

at

Par)

DeliverableCrudeStreams

WestTexasIntermediate

LowSweetMix(ScurrySnyder)

NewMexicanSweet

NorthTexasSweet

OklahomaSweet

SouthTexasSweetBlends of these crude streams are only deliverable if such blends constitute apipeline's designated common stream shipment which meets the grade andquality specifications for domestic crude. TEPPCO Crude Pipeline, L.P.'s andEquilon Pipeline Company LLC's Common Domestic Sweet Streams that meetquality

specifications

in

Rule

200.12(A)(2

7)

are

deliverable

as

Domestic

Crude.

Sulfur:0.42%orlessbyweightasdeterminedbyA.S.T.M.StandardD4294,orits

latestrevision;(3)Gravity:Notlessthan37degreesAPI,normorethan42

degreesAPIasdeterminedbyA.S.T.M.StandardD287,oritslatestrevision;

Viscosity:Maximum60SayboltUniversalSecondsat100degreesFahrenheitas

measuredbyA.S.T.M.StandardD445andascalculatedforSayboltSecondsby

A.S.T.M.StandardD2161;

Reidvaporpressure:Lessthan9.5poundspersquareinchat100degrees

Fahrenheit,asdeterminedbyA.S.T.M.StandardD519196,oritslatestrevision;

BasicSediment,waterandotherimpurities:Lessthan1%asdeterminedby

A.S.T.M.D9688orD4007,ortheirlatestrevisions;

PourPoint:

Not

to

exceed

50

degrees

Fahrenheit

as

determined

by

A.S.T.M.

StandardD97.

(B)ForeignCrudes

DeliverableCrudeStreams

U.K.:BrentBlend(forwhichsellershallbepaida30centperbarreldiscount

belowthelastsettlementprice)

Nigeria:BonnyLight(forwhichsellershallbepaida15centperbarrel

premiumabovethelastsettlementprice)

Nigeria:QuaIboe(forwhichsellershallbepaida15centperbarrelpremium

abovethelastsettlementprice)

Norway:Oseberg

Blend

(for

which

seller

shall

be

paid

a55

cent

per

barrel

discountbelowthelastsettlementprice)

Colombia:Cusiana(forwhichsellershallbepaid15centperbarrelpremium

abovethelastsettlementprice)

Eachforeigncrudestreammustmeetthefollowingrequirementsforgravityand

sulfur,asdeterminedbyA.S.T.M.StandardsreferencedinRule200.12(A)(23):

ForeignCrudeStream

MinimumGravity MaximumSulfurBrentBlend 36.4API 0.46%BonnyLight 33.8API 0.30%QuaIboe 34.5API 0.30%

OsebergBlend

35.4

API

0.30%

Cusiana 34.9API 0.40%


17/91


APRIL 2011 17

2.2.2 The Clearinghouse Margins

Clearingistheprocessbywhichtradesinfuturesandoptionsareprocessed,guaranteed,andsettledby

anentityknownasaclearinghouse.Acompleteclearinghouseactsasthecentralcounterpartytoand

guarantorofalltrades that ithasaccepted forclearing from itsclearingmembers.Theclearinghouse

becomes the buyer to every seller and the seller to every buyer through a process known as

novation.Theexchangeclearinghouseintermediatesallfuturestransactions.Thecreditstatusofthe

counterpartybecomesirrelevantandcontractsbecomefungible.Atransactorneedsonlytoworryabout

thecreditstatusoftheclearinghouse.

Clearing houses have a legal relationship only with entities that they have been admittedas clearing

members.Thatistosay,clearinghouseshaveno legalrelationshipwiththecustomersoftheirclearing

members.

Clearing

members

are

generally

institutions

such

as

futures

commission

merchants

and

broker/dealers that have the financial, risk management, and operational capabilities to function as

clearingmembers.

Clearinghousesperformthefollowingduties:

Match,guarantee,andsettlealltradesandregisterpositionsresultingfromsuchtrades.

Performmarktomarketcalculationsofallopenpositionsat leastonceadayandoversee

theresulting

cash

flows

between

clearing

member

firms.

Managetheriskexposurethatclearingfirmspresenttotheclearinghouse.

Performtheexerciseandassignmentofoptionscontracts.

Facilitate,butnotguarantee,thedeliveryofphysicalcommodities.

Permitmultilateralnettingofpositionsandsettlementpayments.

Assumingcontractsarefungible(interchangeable),clearinghousesoffsetpositions.

Enableclearingmemberstosubstitutethecreditandriskexposureoftheclearinghousefor

thecreditandriskexposureofeachother.

Maintainapackageoffinancialsafeguardsthataredesignedtomitigatelossesintheeventa

clearingmemberdefaultsonitsobligationstotheclearinghouse.

In the event of such a default, meet the obligations of the defaulter by first utilising the

collateralpledgedtoitbythedefaulter.

If such collateral is insufficient to cover theentire amountof thedefaultedamount, then

utilise the components of its financial safeguards package to take care of the remaining

defaultedamount.


18/91


18 APRIL2011

One of the key safeguards in the risk management systems of futures clearing organisations is the

requirementthatmarketparticipantspostcollateral,knownasmargin,toguaranteetheirperformance

on contract obligations. In contrast to the operation of credit margins in the stock market, a futures

margin is not a partial payment for the position being undertaken. Instead, the futures margin is a

performance bond which serves as collateral or as a good faith deposit given by the trader to the

broker.Minimum levelsfor initialandmaintenancemarginsaresetbytheexchange.However,futures

commissionmerchants(FCM)havetherighttodemandhighermarginsfromtheircustomers.

Ina traditional futuresmarket,contractsaremarginedundera riskbasedmargining system,which is

called SPAN. Portfolio margining systems evaluate positions as a group and determine margin

requirementsbasedon theestimatesofchanges in thevalueof theportfolio thatwouldoccurunder

assumedchanges

in

market

conditions.

Margin

requirements

are

set

to

cover

the

largest

portfolio

loss

generatedbyasimulationexercisethatincludesarangeofpotentialmarketconditions.

Markingtomarketensuresthatfuturescontractsalwayshavezerovalue;hencetheclearinghousedoes

not face any risk. Marking to market takes place through marginpayments. At the inception of the

contract,eachpartypaysan initialmargin (typically10%ofthevaluecontracted)toamarginaccount

heldbyitsbroker.Initialmarginmaybepaidininterestbearingsecurities(Tbills)sothereisnointerest

cost.

If

the

futures

price

rises

(falls),

the

longs

have

made

a

paper

profit

(loss)

and

the

shorts

a

paper

loss

(profit).Thebrokerpays losses fromandreceivesanyprofits intothepartiesmarginaccountsonthe

morning following trading. Lossmaking parties are required to restore their margin accounts to the

required levelduring the courseof the sameday bypayment ofvariationmargins in cash;margin in

excessoftherequiredlevelmaybewithdrawnbyprofitmakingparties.

For example, the initial margin for one WTI futures contract is $5000 and the maintenance margin

requirement is $3750 per contract. Consider the following example. Trader X bought a

10September2011deliveryNYMEXcrudeoil futurescontract.Suppose that thecurrentprice is$100

(18February2011).Thebrokerwill require the investor todepositan initialmarginof$50000 in the

marginaccount.Attheendofeachday,themarginaccountisadjustedtoreflecttheinvestorsgainor

loss.Thispracticeisknownasmarkingtomarkettheaccount.Wheneverthemarginaccountexceedsor

fallsbelowthemaintenancemargin($3750 inourexample),thenthecustomerreceivesamargincall

fromitsbroker(orbrokerreceivesamargincallfromtheexchange).Ifthemarginaccountexceedsthe

maintenancemargin,theinvestorisentitledtowithdrawanybalanceinthemarginaccountinexcessof


19/91


APRIL 2011 19

theinitialmarginandwheneveritisbelowthemaintenancelevel,thecustomerhastodeposittobring

themarginaccounttoitsinitialmarginlevel.Theextrafundsdepositedareknownasavariationmargin.

Basically, ifthere isapricedeclinethe investorwhohasa longpositionhastodepositextra funds,so

calledvariation

margin,

to

bring

the

margin

account

to

the

initial

level.

On

the

other

hand,

the

seller

of

thecontractaccountwillbecredited.

Inpractice,thereisactuallyachainofmargins.Traderspostmarginswithbrokers.Nonclearingbrokers

postmarginswithclearingbrokers.Clearingbrokerspostmarginswiththeclearinghouses.Themargin

postedbyclearinghousememberswiththeclearinghouseisknownasaclearingmargin.However,inthe

caseofclearinghousemember,thereisanoriginalmarginbutnomaintenancemargin.

Table2.2:Thefollowingtablesummarisespricechangesandmarginaccount.

Day FuturesPricesofWTICrudeOil($/bbl)DailyGainor

(loss)

Cumulative

Gain(Loss)

MarginAccount

BalanceMarginCall

18Feb 100 50000

21Feb 99.5 5000 5000 45000

22Feb 98 15000 20000 30000 20000

23Feb 99 10000 10000 60000

24Feb

98.5

5000

15

000

55

000

25Feb 97 15000 30000 40000

28Feb 95 20000 50000 20000 30000

01Mar 95 0 50000 50000

02Mar 99 40000 10000 90000

03Mar 99 0 10000 90000

04Mar 100 10000 0 100000

2.2.3 Settlement Price, Volume and Open Interest in Futures Markets

Thesettlementprice istheaverageofthepricesatwhichthecontracttraded immediatelybeforethe

endoftradingfortheday.Thesettlementprice isvery importantsince it isusedtodeterminemargin

requirementsandthefollowingday'spricelimits.

Volume infuturesmarketrepresentsthetotalamountoftradingactivityorcontractsthathavechanged

handsin

agiven

commodity

market

for

asingle

trading

day.

On

the

other

hand,

open

interest

isthe

total


20/91


20 APRIL2011

numberofcontractsoutstandingthatareheldbymarketparticipantsattheendofeachday.Acontractis

createdbyasellerandbuyerofcontract,thereforeopen interestcanbecalculatedasthesumofallthe

longpositions(orequivalently it isthesumofalltheshortpositions).Open interestwill increasebyone

contractifbothpartiestothetradeareinitiatinganewposition(onenewbuyerandonenewseller)and

open interestwilldecreasebyonecontractifbothtradersareclosinganexistingoroldposition(oneold

buyerandoneoldseller).However, ifoneoldtrader ispassingoffhispositiontoanewtrader (oneold

buyersellstoonenewbuyer),openinterestwillnotchange.

2.2.4 Types of Orders

Thesimplesttypeoforderplacedwithabrokerisamarketorder.Amarketorderisanordertobuyor

sellafuturescontractatwhateverprice isobtainableatthetime it isentered inthering,pit,orother

tradingplatform.

However,

there

are

many

other

types

of

orders.

Most

commonly

used

orders

are

the

limitorder,andthestoporderorstoplossorder.

A limitorder isanorder inwhich thecustomerspecifiesaminimumsalepriceormaximumpurchase

price,ascontrastedwithamarketorder,whichimpliesthattheordershouldbefilledassoonaspossible

atthemarketprice.Thus,ifthelimitpriceis$95/bblforoneAprilWTIcontractforaninvestorwanting

tosell,theorderwillbeexecutedonlyatapriceof$95/bblormore.Asopposedtoamarketorder,a

limit

order

will

not

be

executed

unless

the

price

reaches

$95/bbl.

Astoporderorstoplossorderisanorderthatbecomesamarketorderwhenaparticularpricelevelis

reached.Asellstopisplacedbelowthemarket;abuystopisplacedabovethemarket.Thepurposeofa

stoporderistocloseoutapositionifunfavorablepricemovementstakeplace.

2.3 Hedging Using Futures Contracts4

Traditionally,

many

of

the

market

participants

in

futures

markets

were

hedgers.

Hedgers

use

futures

marketstoreduceparticularrisksarisingfromfluctuationsinthepriceoftheunderlyingasset.Ofcourse,

itmightnotbepossibletoeliminatetheriskscompletelyduetobasisrisk,whichwediscusslaterinthe

text.Forthetimebeing,weassumethepossibilityofaperfecthedge,whichcompletelyeliminatesthe

risk.Ahedgemight involvetakinga longposition (longhedge)orashortposition(shorthedge) inthe

futurescontract.

4Futurescontractscanbeusedinsimilarfashionforspeculationpurposesaswell.


21/91


22/91


22 APRIL2011

In July, theproducergets$102100000=$10200000 for thecrudeoil,makinganet revenue from its

salesofapproximately$9900000.Ontheotherhand,ifthespotpriceinJulyturnedouttobe$90/bbl,

thentheproducercompanygainsfromitsfuturescontractapproximately

100000($99$90)=$900000

andgets$90100000=$9000000forthecrudeoilinspotmarket.Againhere,thetotalnetrevenuefor

theoilfortheproducerwouldbe$9900000.NomatterwhathappenstothespotpriceinJuly,entering

intothefuturescontractallowstheproducertofixitsnetrevenuetothebarrelofoiltimesthepriceper

barrel.Therefore,hedgingusingfuturescontractseliminatestheuncertaintyovertherevenue.

2.4 Basis Risk

Up until now, we assumed that hedgers can completely eliminate risks by taking futures positions

oppositetotheircashpositions.However,inrealityitisdifficulttoeliminateallrisks.Inordertoeliminate

allrisksassociatedwithcashpositions,thehedgermustknowtheprecisedateinthefuturewhenanasset

wouldbeboughtorsold.Evenifthehedgerknowstheexactdateofpurchaseorsale,hemighthaveto

close his/her futures position before its delivery month, i.e. there might be a mismatch between the

hedge period and available delivery date. Even then, the hedger would need to find the same asset

underlying the futures contract as the asset s/he is planning to buy or sell. For all these reasons, the

hedgerwillfacebasisrisk,whichcanbedefinedasthedifferencebetweenthespotpriceoftheassetto

behedged

and

the

futures

price

of

the

contract

used.

If theassettobehedgedandtheassetunderlying the futurescontractarethesame,thenweshould

expectthebasisrisktobezeroattheexpirationofthefuturescontract.Priortoexpiration,thebasiscan

benegativeorpositive. If thebasis ispositive, i.e.thespotprice isgreater than the futuresprice,the

situation isknownasbackwardation. If,on theotherhand,thebasis isnegative, i.e.spotprice is less

thanthefuturesprice,thesituationisknownascontango.

If,ontheotherhand,theassettobehedgedandtheassetunderlyingthefuturescontractaredifferent

asituationknownascrosshedgingthenweshouldexpectthebasisrisktobedifferentfromzeroeven

atexpiration.Sometimes,itisnotpossibletofindfuturescontractsforsomecommodities.Consideran

airlinecompany,which isconcernedabout the futurepriceofjet fueloil, rather thancrudeoil.Since

there is no futures contract onjet fuel oil, the airline company tries to find an asset underlying the

futurescontractwhich ishighlycorrelatedwiththeassettobehedged.Highcorrelationresults in low

basisriskandhighhedgeeffectiveness.


23/91

INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS 3. SWAPS

APRIL 2011 23

3. SWAPS

Forwardorfuturescontractssettleonasingledate.However,manytransactionsoccurrepeatedly

Forexample,anairlinecompanybuysjetfueloilonanongoingbasis.Ifamanagerseekingtoreducerisk

confronts a risky payment stream, what is the easiest way to hedge this risk? You can enter into a

separateforwardcontractforeachpaymentyouwishtohedge.However,itcouldbemoreconvenient

andentaillowertransactioncosts,iftherewereasingletransactionthatwecouldusetohedgeastream

ofpayments.Swapsserveexactlythispurpose.

Swaps are agreements between two companies to exchange cash flows in the future according to a

prearrangedformula.Swaps,therefore,mayberegardedasaportfolioofforwardcontracts.Swapsare

tradedon

over

the

counter

derivatives

markets

and

are

most

common

in

interest

rates,

currencies

and

commodities.Theyoftenextendmuchfurtherintothefuturethanexchangecontracts.Thepartiestoa

swapset:

thenotionalamount;

thetenorormaturityoftheswap;

thepaymentdates;

thefloatingpriceindex;and

thefixedprice.

Thefollowingdiscussionontheswapmarketanddevelopmentintheswapmarketexcerptsfromthe

CFTCCommoditySwapDealers&IndexTraderswithCommissionRecommendationsreport.5

Thefirstswapcontractswerenegotiated in1981. Inordertoreduceoverallfundingcostsfor

bothparties,theWorldBankandIBMenteredintowhathasbecomeknownasacurrencyswap.

TheswapessentiallyinvolvedaloaninSwissfrancsbyIBMtotheWorldBankandaloaninU.S.

dollarsbytheWorldBanktoIBM.Thisstructureofswappingcashflowsultimatelyservedasthe

templateforswapsonanynumberoffinancialassetsandcommodities.

Swaps serve as an effective hedging vehicle in much the same way that financial futures

contractsdo.Forexample,atypicalfuturescontracthasmanyofthesamecharacteristicsasa

swap inthat it isessentiallyacontractwherethebuyerofthecontractagreesattheoutsetto

payafixedpriceforacommodityinreturnforfuturedeliveryofthecommodity,whichwillhave

anuncertainorfloatingvalueatthetimeofexpirationofthecontract.

5Seehttp://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf


24/91

3. SWAPS INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

24 APRIL2011

Thepartyofferingtheswap,typicallycalledaswapdealer, takesonanypricerisksassociated

with the swap and thus must manage the risk of the commodity exposure. In the early

developmentofswapmarkets, investmentbanksoftenserved inabrokeringcapacitytobring

togetherpartieswithoppositehedgingneeds.ThecurrencyswapbetweentheWorldBankand

IBM,forexample,wasbrokeredbySalomonBrothers.Whilebrokeringswapseliminatesmarket

price and credit risk to the broker, the process of matching and negotiating swaps between

counterpartieswithoppositehedgingneedscouldbedifficult.Asa result, swapbrokers (who

tookonnomarketrisk)evolvedintoswapdealers(whotookthecontractontotheirbooks).As

noted,whenaswapdealer takesaswaponto itsbooks, it takesonanyprice risksassociated

with the swap and thus must manage the risk of the commodity exposure. In addition, the

counterpartybearsacreditriskthattheswapdealermaynothonouritscommitment.Thisrisk

canbe

significant

in

the

case

of

aswap

dealer

because

itispotentially

entering

into

numerous

transactionsinvolvingmanycounterparties,eachofwhichexposestheswapdealertoadditional

creditrisks.

Asa resultof these risks, therehasbeenanatural tendency for financial intermediaries (e.g.,

commercial banks, investment banks, insurance companies) to become swap dealers. These

firmstypicallyhavethecapitalisationtosupporttheircreditworthinessaswellastheexpertise

to

manage

the

market

price

risks

that

they

take

on.

In

addition,

for

particular

commodity

classes,

suchasagricultureandenergy,largecommercialcompaniesthathavetheexpertisetomanage

marketpriceriskshavesetupaffiliatestospecialiseasswapdealersforthosecommodities.The

utilityofswapagreementsasahedgingvehiclehasledtosignificantgrowthinboththesizeand

complexityoftheswapmarket.Duringtheearlyperiodinthedevelopmentoftheswapmarket,

themajorityofswapagreementsinvolvedfinancialassets.Infact,eventodaythevastmajority

ofswapsoutstandinginvolveeitherinterestratesorcurrencies.

The OTC swap market has grown significantly because, for many financial entities, the OTC

derivatives products offered by swap dealers have distinct advantages relative to futures

contracts. While futures markets offer a high degree of liquidity (i.e., the ability to quickly

executetradesduetothehighnumberofparticipantswillingtobuyandsellcontracts),futures

contractsaremorestandardised,meaningthattheymaynotmeettheexactneedsofahedger.

Swaps,ontheotherhand,offeradditionalflexibilitysincethecounterpartiescantailortheterms

ofthecontracttomeetspecifichedgingneeds.


25/91


APRIL 2011 25

Asanexampleoftheflexibilitythatswapscanoffer,consideragainthecaseofanairlinewanting

tohedgefuturejetfuelpurchases.Currentlythereisnojetfuelfuturescontractavailabletothe

airlines to directly hedge their price exposure. Contracts for crude oil (from whichjet fuel is

made)andheatingoil(whichisafuelhavingsimilarchemicalcharacteristicstojetfuel)doexist.

Butwhilethesecontractscanbeusedtohedgejetfuel,thedissimilaritiesbetweenjetfueland

crudeoilorheatingoilmeanthattheairlinewillinevitablytakeonwhatwasreferredtoabove

asbasisrisk.Thatis,thepriceofjetfuelandthepricesofthesefuturescontractswillnottendto

moveperfectlytogether,diminishingtheutilityofthehedge.

In contrast, swap dealers can offer the airline the alternative of entering into a contract that

directlyreferencesthecashpriceforjetfuelatthespecifictimeandlocationwheretheproduct

isneeded.

By

creating

acustomised

OTC

derivative

product

that

specifically

addresses

the

price

risks facedby theairline,by takingon theadministrativecostsassociatedwithmanaging that

contractovertime,andbyassumingthepricerisksattendanttothatcontract,theswapdealer

facilitatestheairlinesriskmanagement.

Whenacommercialentityusesaswaptooffsetitsrisk,theswapdealerassumesthepricerisk

ofthecommodity.Forexample,iftheswapdealerentersintoajetfuelswapwithanairline,the

airline

agrees

to

periodically

pay

a

fixed

amount

on

the

swap

while

the

swap

dealer

pays

a

floatingamountbasedonacashmarketprice.Ateachpointintimewhenthepaymentsaredue,

anettingoftheobligationstakesplaceandthepartyresponsibleforthelargerpaymentpaysthe

difference to theotherparty.Thus, ifprices rise, the floatingpaymentwillbe larger than the

fixedpriceandtheswapdealerpaysthenetamounttotheairline.Conversely,ifpricesfall,the

airlinewillberequiredtomakeapaymenttotheswapdealer.Recall,however,thatwhenthe

airlinemakesapaymentontheswaptotheswapdealer, itmeansthatatthesametime, it is

payinga lowerprice toacquirejet fuel in thecashmarket.Theswapdealer,however,hasno

naturaloffsettingtransactiontocounterbalancetherisk.That iswhyswapdealerswill, inturn,

hedgethispriceriskintheregulatedfuturesmarkets.

Swapagreementshavealsobecomeapopularvehicle fornoncommercialparticipants,suchas

hedgefunds,pensionfunds, largespeculators,commodity indextraders,andotherswith large

poolsofcash,togainexposuretocommodityprices.Recently,portfoliomanagershavesought

to invest incommoditiesbecauseof the lackofcorrelation,orevennegativecorrelation, that

commoditiestend

to

have

with

traditional

investments

in

stocks

and

bonds.

In

addition,

because


26/91

3. SWAPS INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

26 APRIL2011

oftheabilitytotailortransactions,swapscanrepresentamoreefficientmeansbywhichthese

participants can enter the market. Hence, many of the benefits that swap agreements offer

commercial hedgers also attract noncommercial interests to the swap market. Since swap

dealersarewilling toenter into swap contractsoneither side ofamarket,at times theywill

enter into swaps that create offsetting exposures, reducing the swap dealers overall market

price riskassociatedwith the firms individualpositionsopposite its counterparties.Since it is

unlikely,however,thataswapdealercouldcompletelyoffsetthemarketpricerisksassociated

withitsswapbusinessatalltimes,dealersoftenenterthefuturesmarketstooffsettheresidual

marketpricerisk.Asaresultofthegrowthoftheswapmarketandthedealerswhosupportthe

market,therehasbeenanassociatedgrowthintheopeninterestofthefuturesmarketsrelated

to thecommodities forwhichswapsareoffered,as theseswapdealersattempt to layoff the

residualrisk

of

their

swap

book.

Amorerecentphenomenoninthederivativesmarkethasbeenthedevelopmentofcommodity

index funds and exchangetraded funds for commodities (ETFs) and exchangetraded notes

(ETNs), which are mainly transacted through swap dealers. Both products are designed to

producea return thatmimicsapassive investment ina commodityorgroupof commodities.

ETFsandETNsare tradedon securitiesexchangesandarebackedbyphysicalcommoditiesor

long

futures

positions

held

in

a

trust.

Commodity

index

funds

are

funds

that

enter

into

swap

contractsthattrackpublishedcommodity indexessuchastheS&PGoldmanSachsCommodity

IndexortheDowJonesAIGCommodityIndex.

3.1 Mechanics of Swaps

When two parties enter a swap contract, one party makes a payment to the other depending upon

whether a price turns out to be greater or less than a reference price that is specified in the

swapcontract.

Forexamplebyentering intoanoilswap,anoilbuyerconfrontingastreamofuncertainoilpayments

can lock inafixedpriceforoiloveraperiodoftime.Theswappaymentswouldbebasedonthefixed

priceforoilandamarketpricethatvariesovertime.

SupposeUntiedAirlines (UA) isgoingtobuy100000barrelsofoiloneyearfromtodayandtwoyears

from today. Suppose that the forward price for delivery in one year is $75/bbl and in two years is

$90/bbl.

Suppose

oneyear

and

two

year

zero

coupon

bond

yields

are

5%

and

5.5%.

UA

can

use

a


27/91


APRIL 2011 27

forwardcontracttoguaranteethecostofbuyingoilforthenexttwoyears.Thepresentvalueofthiscost

willbe

$75

1.05

$90

1.055 $152.29

UAcouldinvestthisamounttobuyoilinoneandtwoyears,oritcouldpayanoilsupplier$152.29who

would commit to delivering one barrel in each of the next two years. This is a prepaid swap. If the

paymentisdoneaftertwoyears,thisisapostpaidswap.

Typically,a swapwill callequalpayments ineachyear,or$82.28/bbl.This is thepriceofa twoyear

swap.However,anypayments thathaveapresentvalueof$152.29areacceptable. Inexchange, the

swap

counterparty

delivers

100

000

barrels

of

crude

oil

each

year.

The

notional

value

of

the

swap

can

be

calculatedbymultiplyingallcashflowsby100000.

Instead of delivery, if the swap counterparties settled with cash, the oil buyer, UA, pays the swap

counterparty the difference between $82.28/bbland the spot price (if the difference is negative, the

counterpartypaysthebuyer),andtheoilbuyerthenbuystheoilinthespotmarket.Forexample,ifthe

spotpriceis$90/bbl,theswapcounterpartypaysthebuyer

Spotpriceswapprice=$90$82.28=$7.72

Ifthe

spot

price

is$80/bbl,

then

oil

buyer

makes

apayment

to

the

swap

counterparty

Spotpriceswapprice=$80$82.28=$2.28

Whateverthespotprice,thenetcosttothebuyeristheswapprice,$82.28/bbl

Althoughtheswapprice isclosetothemeanofforwardprices($82.50/bbl), it isnotexactlythesame.

Why?Supposetheswappriceis$82.50/bbl,thentheoilbuyerwouldthenbecommittingtopaymore

than$7.50morethantheforwardpricethefirstyearandwouldpay$7.50 lessthantheforwardprice

thesecondyear.Thusrelativetotheforwardcurve,thebuyerwouldhavemadeaninterestfreeloanto

thecounterparty.

Iftheswappriceis$82.28,thenweareoverpaying$7.28inthefirstyearandunderpaying$7.72inthe

second year, relative to the forward curve. The swap is equivalent to being longon the two forward

contracts,coupledwithanagreement to lend$7.28 to thecounterparty in the firstyear,and receive

$7.72insecondyear.

The interest rate on this loan is $7.72/$7.281=6%. Where does 6% come from? 6% is the one year

impliedforward

yield

from

year

one

to

year

two.


28/91

4. OPTIONS INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

28 APRIL2011

4. OPTIONS

Anoption isacontractthatgivestheoptionholdertheright/option,butnoobligation,tobuyorsella

security (ora futurescontract) totheoptionwriter/sellerat (orup to)agiventime in the future (the

expirydate

or

maturity

date)

for

apre

specified

price

(the

strike

price

or

exercise

price,

K).

The option purchaser (holder) is the person who buys a call or a put option and pays the option

premium,i.e.thepersonwhoestablishesalongoptionsposition.Thisisthepartywiththeright,butnot

theobligation,underthetermsofthecontract.

The option writer, or grantor, is the person who sells a call or put option and receives the option

premium, i.e.thepersonwhoestablishesashortposition.Thisparty isobligatedtoperformunderthe

termsof

such

an

option.

Acalloptiongivestheholdertherighttobuyasecurityandaputoptiongivestheholdertherighttosell

asecurity.Wheretheunderlyinginterestisrepresentedbyafuturescontract,therighttobuyisactually

arighttobelongonafuturescontractataspecifiedpricelevel.Conversely,therighttosellrepresents

the right toashort futurespositionataspecifiedprice level.Optionsallowone to takeadvantageof

changesinfuturespriceswithoutactuallyhavingapositioninthefuturesmarket.

Optionscan

be

American,

European

or

Bermudan.

American

options

can

be

exercised

at

any

time

prior

toexpiry.Europeanoptionscanonlybeexercisedattheexpiry.Bermudanoptioncanonlybeexercised

duringthespecifiedperiod.

Thepriceatwhichthefuturescontractunderlyinganoptioncanbepurchased(ifacall)orsold(ifaput)

is called the strike price or the exercise price. In the call and put definitions above, this is the

predeterminedprice.

Itisimportant

to

note

that

for

every

option

buyer

there

isan

option

seller.

At

any

time

before

the

option

expires,theoptionbuyercanexercisetheoption.Sincethebuyerdecideswhethertoexercise,theseller

cannotmakemoneyatexpiration.Totakethisrisk,theseller iscompensatedbytheoptionpremium,

which isagreedwhenthecontract issigned.Theoptionpremium isdeterminedthroughtradingonan

exchangemarket.Therefore,weshouldexpecttoseedifferentoptionpremiafordifferentstrikeprices.

Effectively, the exercise of a call gives the option purchaser a long position in theunderlying futures

contract at the options strike price; the exercise of a put option gives the option purchaser a short

futurespositionattheoptionsstrikeprice.Theoptionbuyercanalsoselltheoptiontosomeoneelseor


29/91

INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS 5. REFERENCES

APRIL 2011 29

donothingand let theoptionexpire.Thechoiceofaction is leftentirelyup to theoptionbuyer.The

optionbuyerobtainsthisrightbypayingthepremiumtotheoptionseller.

Acalloptionbuyerwillonlychoosetoexerciseifthestockpriceisgreater/higherthanthestrikeprice.If

thestock

price

isless

than

the

strike

price,

the

investor

would

clearly

choose

not

to

exercise

the

option,

and the investor only loses the option premium. On the other hand, a put option buyer will only to

choosetoexercisetheoptionwhenthestockpriceislessthanstrikeprice.Ifthestockpriceismorethan

thestrikeprice, the investorwouldclearlychoosenot toexercise theoptionandwouldonly lose the

optionpremium.

What about the option seller? The option seller receives the premium from the option buyer. If the

optionbuyerexercisestheoption,theoptionsellerisobligatedtotaketheoppositefuturespositionat

the same strike price. Because of the sellers obligation to take a futures position if the option is

exercised,anoptionsellermustpostamarginandfacesthepossibilitythatthemarginwillbecalled if

themarketmovesagainsthispotentialfuturesposition.

4.1 Call Option

A call option is a contract where the buyer has the right, but not the obligation, to buy an underlying

security.Sincethebuyerdecideswhetherornottobuy,thesellercannotmakemoneyatexpiration.Totake

this

risk,

the

seller

is

compensated

by

the

option

premium,

which

is

agreed

when

the

contract

is

signed.

Consider a call option on the S&R index with six months to expiration and strike price of $1000 and

premiumof$93.81.6Andassumethattheriskfreerateis2%oversixmonths.Supposethattheindexin

sixmonths is$1100.Clearly it isworthwhile topay the$1000strikeprice toacquire the indexworth

$1100.Ifontheotherhandtheindexis$900atexpiration,itisnotworthwhilepayingthe$1000strike

pricetobuytheindexworth$900.Inthiscase:

Thebuyerisnotobligedtobuytheindexandhencewillonlyexercisetheoptionifthepayoffis

positive.

Purchasedcallpayoff=max(0,STK)

Inourexample,K=1000.IfS=1100thenthecallpayoff

Purchasedcallpayoff=max(0,11001000)=$100

IfS=900,thenthecallpayoffis

Purchasedcallpayoff=max(0,9001000)=$0

6ThediscussionsoncallandputoptionsdrawsuponMcDonald(2006).


30/91


30 APRIL2011

Thepayoffdoesnottake intoaccountthe initialcost(optionpremium)ofacquiringtheposition.Fora

purchased option, the premium is paid at the time the option is acquired. In computing profit at

expiration,weusethefuturevalueofthepremium.

Purchasedcallprofit=max(0,STK)futurevalueofoptionpremium

Purchasedcallprofit=Purchasedcallpayofffuturevalueofoptionpremium

Iftheindexattheexpirationis1100,thenprofitis

Purchasedcallprofit=max(0,11001000)93.811.02=$4.32

Ifthe indexattheexpiration is900,thentheownerdoesnotexercisetheoption.The loss

willbefuturevalueofoptionpremium.Maximumlosswillbetheoptionpremium.

Purchasedcallprofit=max(0,9001000)93.811.02=$95.68

250

200

150

100

50

0

50

100

150

200

250

800 850 900 950 1000 1050 1100 1150 1200

Payoff($)

S&RIndexPrice($)

ThePayoff

at

Expiration

with

aStrike

Price

of

$1000

CallPayoff


31/91


APRIL 2011 31

Theoptionwriter(sellerofoption)hasashortpositioninacalloption.Thewriterreceivesthe

premiumfortheoptionandthenhasanobligationtoselltheunderlyingsecurityinexchangefor

thestrikepriceiftheoptionbuyerexercisestheoption.

Thepayoffandprofittoawrittencallarejusttheoppositeofthoseforapurchasedcall.

Writtencallpayoff= max(0,STK)=min(0,KST)

Writtencallprofit= max(0,STK)+futurevalueofoptionpremium

Inourexample, if S=1100 then the optionwriter payoffwillbe $100 and profitwillbe

$4.32.Ifontheotherhand,S=900,thenpayoffwillbe0andprofitwillbethefuturevalueof

premium,$95.68.

250

200

150

100

50

0

50

100

150

200

800 850 900 950 1000 1050 1100 1150 1200

Profit($)

S&RIndexPrice($)

ProfitatExpirationforCallOptionwithK=1000andLongForward

CallProfit

LongForwardProfit

Indexprice=1095.68


32/91


32 APRIL2011

4.2 Put Option

Aputoption isacontractwherethebuyerhastherighttosell,butnottheobligation.Sincethebuyer

decides whether to sell, the seller cannot make money at expiration. To take this risk, the seller is

compensatedbytheoptionpremium,whichisagreedwhenthecontractissigned.

Example: PutOption

Consider a put option on the S&R index with six months toexpiration and strike price of $1000 and

premium

of

$74.20.

And

assume

that

the

risk

free

rate

is

2%

over

six

months.

Suppose

that

the

index

in

250

200

150

100

50

0

50

100

150

200

250

800 850 900 950 1000 1050 1100 1150 1200

Payoff($)

S&RIndex

Price

($)

PayoffforOptionWriterwithStrikePriceof$1000

WrittenCallPayoff

200

150

100

50

0

50100

150

200

250

800 850 900 950 1000 1050 1100 1150 1200

Profit($)

S&RPriceIndex($)

ProfitforOptionWriterwithStrikePriceof$1000

WrittenCallProfit

ShortForwardIndexPrice=

1020

IndexPrice=1095.68


33/91


APRIL 2011 33

sixmonths is$1100.Clearly it isnotworthwhile to sell the indexworth$1100 for the strikepriceof

$1000.Ifontheotherhandtheindexis$900atexpiration,itisworthwhilesellingtheindexfor$1000.

Thebuyerisnotobligedtoselltheindexandhencewillonlyexercisetheoptionifthepayoffis

positive.

Purchasedput

payoff

=max(0,K

ST)

Inourexample,K=1000.IfS=1100thentheputpayoff

Purchasedputpayoff=max(0,10001100)=$0

IfS=900,thentheputpayoffis

Purchasedputpayoff=max(0,1000900)=$100

Thepayoffdoesnottake intoaccounttheinitialcostofacquiringtheposition.Forapurchasedoption,

thepremium ispaidat the time theoption isacquired. Incomputingprofitatexpiration,weuse the

futurevalueofthepremium.

Purchasedputprofit=max(0,KST)futurevalueofoptionpremium

Purchasedputprofit=Purchasedputpayofffuturevalueofoptionpremium

Iftheindexattheexpirationis1100,thentheoptionbuyerwillnotexercisehisrighttosell

andthemaximumlosswillbethefuturevalueoftheoptionpremium.

Purchasedputprofit=max(0,10001100)74.21.02=$75.68

Iftheindexattheexpirationis900,thentheownerexercisestheoptioni.e.sells.Theprofit

willbe

Purchasedput

profit

=max(0,1000

900)

74.21.02=$24.32

Theoptionwriter(sellerofoption)hasa longposition inaputoption.Thewriterreceivesthe

premiumfortheoptionandthenhasanobligationtobuytheunderlyingsecurityinexchangefor

thestrikepriceiftheoptionbuyerexercisestheoption.

Thepayoffandprofittoawrittenputarejusttheoppositeofthoseforapurchasedput.

Writtenputpayoff= max(0,KST)=min(0,STK)

Writtenputprofit=max(0,KST)+futurevalueofoptionpremium

In

our

example,

if

S=1100

then

the

put

buyer

will

not

exercise

the

put,

thus

put

writer

earns

profit,whichwillbeoptionpremium. If,on theotherhand,S=900, then theoptionbuyer

exercisestheoptionandtheoptionseller(writer)willlose$24.32(100+$75.68).

4.3 Moneyness of Options

Optionsaregenerallyreferredtoasinthemoney,atthemoney,oroutofmoney.Themoneynessof

an option depends on the strike price (K) relative to the spot (St)/forward (Ft) price of the

underlyingasset.


34/91


34 APRIL2011

Anoptionissaidtobeinthemoneyiftheoptionhaspositivevalueifexercisedrightnow:

St >K forcalloptionsandSt K forcallandFt


35/91


APRIL 2011 35

5. REFERENCES

CFTC (2008) Commodity Swap Dealers & Index Traders with Commission Recommendations.

http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcstaffreportonswapdealers09.pdf

McDonald,RobertL.(2006).DerivativesMarkets.2ndEdition,AddisonWesley.

Weber, Ernst Juerg (2008). A Short History of Derivative Security Markets. Available at SSRN:

http://ssrn.com/abstract=1141689


36/91

6. GLOSSARYOF THE DERIVATIVESMARKET INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

36 APRIL2011

6. GLOSSARY OF THE DERIVATIVES MARKET TERMS7

A

Abandon:Toelectnottoexerciseoroffsetalongoptionposition.

Accommodation Trading: Noncompetitive trading entered into by a trader, usually to assist another

withillegaltrades.

Accumulator: A contract inwhich the seller agrees todelivera specified quantity of a commodity or

otherasset to thebuyeratapredeterminedpriceonaseriesofspecifiedaccumulationdatesovera

specifiedperiodoftime.Thecontracttypicallyhasaknockoutprice,which,ifreached,willtriggerthe

cancellationofall remainingaccumulations.Moreover, theamountof thecommodity tobedelivered

maybedoubledorotherwiseadjustedonthoseaccumulationdateswhenthepriceoftheassetreaches

aspecified

price

different

from

the

knockout

price.

Actuals:Thephysicalorcashcommodity,asdistinguished froma futurescontract.SeeCashandSpot

Commodity.

Agency Bond: A debt security issued by a governmentsponsored enterprise such as Fannie Mae or

FreddieMac,designedtoresembleaU.S.Treasurybond.

AgencyNote: A debt security issued by a governmentsponsored enterprise such as Fannie Mae or

FreddieMac,designedtoresembleaU.S.Treasurynote.

Aggregation:Theprincipleunderwhichallfuturespositionsownedorcontrolledbyonetrader(orgroup

of traders acting in concert) are combined to determine reporting status and compliance with

speculativepositionlimits.

AgriculturalTradeOptionMerchant:Anypersonthat is inthebusinessofsolicitingorenteringoption

transactionsinvolvinganenumeratedagriculturalcommoditythatarenotconductedorexecutedonor

subjecttotherulesofanexchange.

Algorithmic Trading: The use of computer programs for entering trading orders with the computer

algorithminitiatingordersorplacingbidsandoffers.

Allowances:(1)

The

discounts

(premiums)

allowed

for

grades

or

locations

of

acommodity

lower

(higher)

than the par (or basis) grade or location specified in the futures contract. See Differentials. (2) The

tradablerighttoemitaspecifiedamountofapollutantunderacapandtradesystem.

AmericanOption:Anoption thatcanbeexercisedatany timepriortooron theexpirationdate.See

EuropeanOption.

ApprovedDeliveryFacility: Anybank, stockyard,mill, storehouse,plant,elevator,orotherdepository

thatisauthorizedbyanexchangeforthedeliveryofcommoditiestenderedonfuturescontracts.

7Source:CFTC.Thisglossaryisavailableathttp://www.cftc.gov/ucm/groups/public/@educationcenter/documents/file/cftcglossary.pdf


37/91

INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS 6. GLOSSARYOF THE DERIVATIVESMARKET

APRIL 2011 37

Arbitrage:Astrategyinvolvingthesimultaneouspurchaseandsaleofidenticalorequivalentcommodity

futures contracts or other instruments across two or more markets in order to benefit from a

discrepancyintheirpricerelationship.Inatheoreticalefficientmarket,thereisalackofopportunityfor

profitablearbitrage.SeeSpread.

Arbitration: A process for settling disputes between parties that is less structured than court

proceedings. The National Futures Association arbitration program provides a forum for resolving

futuresrelateddisputesbetweenNFAmembersorbetweenNFAmembersandcustomers.Otherforums

forcustomercomplaintsincludetheAmericanArbitrationAssociation.

ArtificialPrice: A cash market or futures price that has been affected by a manipulation and is thus

higherorlowerthanitwouldhavebeenifitreflectedtheforcesofsupplyanddemand.

AsianOption: An exotic option whose payoff depends on the average price of the underlying asset

duringaspecified

period

preceding

the

option

expiration

date.

Ask:Thepricelevelofanoffer,asinbidaskspread.

AssignableContract:Acontract thatallows theholdertoconveyhis rightstoathirdparty.Exchange

tradedcontractsarenotassignable.

Assignment:Designationbyaclearingorganizationofanoptionwriterwhowillberequiredtobuy(in

thecaseofaput)orsell(inthecaseofacall)theunderlyingfuturescontractorsecuritywhenanoption

hasbeenexercised,especiallyifithasbeenexercisedearly.

Associated

Person

(AP):

An

individual

who

solicits

or

accepts

(other

than

in

a

clerical

capacity)

orders,

discretionaryaccounts,orparticipationinacommoditypool,orsupervisesanyindividualsoengaged,on

behalf of a futures commission merchant, an introducing broker, a commodity trading advisor, a

commoditypooloperator,oranagriculturaltradeoptionmerchant.

AttheMarket:Anordertobuyorsellafuturescontractatwhateverpriceisobtainablewhentheorder

reachesthetradingfacility.SeeMarketOrder.

AttheMoney:Whenanoption'sstrikeprice isthesameasthecurrenttradingpriceoftheunderlying

commodity,theoptionisatthemoney.

AuctionRateSecurity:Adebtsecurity,typically issuedbyamunicipality, inwhichtheyield isreseton

eachpaymentdateviaaDutchauction.

AuditTrail:Therecordoftradinginformationidentifying,forexample,thebrokersparticipatingineach

transaction,thefirmsclearingthetrade,thetermsandtimeorsequenceofthetrade,theorderreceipt

andexecutiontime,and,ultimately,andwhenapplicable,thecustomersinvolved.

AutomaticExercise:Aprovisioninanoptioncontractspecifyingthatitwillbeexercisedautomaticallyon

theexpirationdateifitisinthemoneybyaspecifiedamount,absentinstructionstothecontrary.


38/91

6. GLOSSARYOF THE DERIVATIVESMARKET INTERNATIONAL ENERGYAGENCY THE MECHANICSOF THE DERIVATIVESMARKETS

38 APRIL2011

B

BackMonths:Futuresdeliverymonthsotherthanthespotorfrontmonth(alsocalleddeferredmonths).

BackOffice: The department in a financial institution that processes and deals and handles delivery,

settlement,andregulatoryprocedures.

Backpricing:Fixing thepriceofacommodity forwhichthecommitmenttopurchasehasbeenmade in

advance.Thebuyercanfixthepricerelativetoanymonthlyorperiodicdeliveryusingthefuturesmarkets.

BackSpread:Adeltaneutralratiospreadinwhichmoreoptionsareboughtthansold.Abackspreadwill

beprofitableifvolatilityincreases.SeeDelta.

Backwardation:Marketsituation inwhichfuturespricesareprogressively lower inthedistantdelivery

months.Forinstance,ifthegoldquotationforJanuaryis$960.00perounceandthatforJuneis$945.00

perounce,thebackwardationforfivemonthsagainstJanuaryis$15.00perounce.(Backwardationisthe

oppositeof

contango).

See

Inverted

Market.

BangingtheClose:Amanipulativeordisruptivetradingpracticewherebyatraderbuysorsellsa large

numberof futurescontractsduring theclosingperiodofa futurescontract (that is, theperiodduring

which the futures settlement price is determined) in order to benefit an even larger position in an

option,swap,orotherderivativethatiscashsettledbasedonthefuturessettlementpriceonthatday.

Banker'sAcceptance: A draft or bill of exchange accepted by a bank where the accepting institution

guaranteespayment.Usedextensivelyinforeigntradetransactions.

Basis:The

difference

between

the

spot

or

cash

price

of

acommodity

and

the

price

of

the

nearest

futures

contractforthesameorarelatedcommodity(typicallycalculatedascashminusfutures).Basisisusually

computed in relation to the futures contract next to expire and may reflect different time periods,

productforms,grades,orlocations.

Bas

Oil Derivatives

Documents