Key Learning Points: Lesson 10
- Swaps are exchanges of payments between two parties and are strictly financial in nature.
- They can be used in lieu of futures contracts and are, in fact, “forward” contracts.
- They are non-exchange traded instruments.
- They can be used for hedging or outright trading.
- “Fixed-for-floating” swaps use current NYMEX market prices and final settlement prices to determine the balance of payments under the agreements.
- Spreads represent the price difference between commodity locations, relationships, and timeframes.
- They can also be used for hedging or outright trading (arbitrage).
- The most common types of spreads are location, time (storage), and inter-commodity.
- Inter-commodity spreads can be by oil refiners, midstream natural gas companies, and electricity generators to lock-in margin.
- Options are a simple and less costly way to hedge price risk than the outright purchase or sale of energy financial contracts.
- They give the buyer the right but not the obligation to buy or sell the underlying energy commodity contracts at the “strike price.”
- The seller, or “writer,” of the option assumes all risk.
- Options can be used for hedging or outright trading.
- Commercial entities concerned about rising energy prices, i.e., refiners, would enter into a “call” option, thereby establishing a maximum, or “ceiling,” price for their commodity needs.
- Commercial entities concerned about falling energy prices, i.e., producers, would enter into a “put” option, thereby establishing a minimum or “floor” price for their commodity.
- The Black-Sholes model is the most popular options valuation model.
In the next section, we will discuss the need for risk controls in energy commodity trading. Given your understanding of the complexities of financial derivatives, you should now realize how important a system of "checks-and-balances" is for any energy trading company. However, if the controls put in place are not followed, catastrophic losses can occur......Enron.
Quiz and Activities
- Lesson 10 Quiz
- Lesson 10 Black-Sholes Model Exercise
- Fundamental Factors
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