Key Learning Points: Lesson 8
- The financial derivative contracts for energy commodities provide actual supply and market for commercial players.
- Fixed prices for the commodities can be established as well.
- Utilizing financial derivatives to reduce one’s price and supply/market risk is known as “hedging.”
- Commercial entities must take a financial position that is the opposite of their physical position in order for the hedge transaction to be successful.
- Producers of the commodity are said to be “long” the physical product and therefore, must be Sellers in the financial market (sell contracts).
- Consumers for the commodity are said to be “short” the physical product and therefore, must be Buyers in the financial market (buy the contracts).
- Companies that lease storage capacity can hedge their price, supply, and market risk through buying contracts in one month and selling contracts in a subsequent month. This is known as a “time” or “storage” spread.
- By taking these opposite positions, price changes in one market are offset by price changes in the other market. When these occur on a 1:1 basis, it is referred to as a “perfect” hedge.
- These are known as “simple, fixed-price” hedges and represent the “first layer” of any more complex hedge transaction.
In the next lesson, we will explore other, more advanced, financial derivatives that can also be used for hedging. Among these are Swaps, Spreads and Options. They are mostly traded in the "over-the-counter" markets, that is, non-exchange traded. "OTC" encompasses electronic trading platforms as well as "voice" Brokers where transactions occur over the phone.
Price exercise (previous page)
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