Errera & Brown - Chapters 4 & 6
Key Points of Emphasis
- Non-exchanged traded financial derivatives are known as "over-the-counter" (OTC).
- Swaps and Spreads trade OTC while Options are exchange and OTC traded.
- Swaps are exchanges of payments between two Buyers. They are financially settled.
- Swaps are normally "fixed-for-floating" whereby one price is the current market price ("fixed") and the other price is the future settlement price ("floating").
- Spreads are trades which occur between commodity locations and times, as well as intra-market and inter-market.
- Options give the Holder of the Option the right but not the obligation to buy or sell a commodity at a particular price for a specific date and location in the future.
- Options are price risk insurance and a premium is paid for Options contracts.
- Premiums paid are substantially less than the outright commodity contracts.
- Option premiums are determined using mathematical models. The most well-known is the Black-Sholes.
- "Put" Options give the Buyer a "floor" price, whereas "Call" Options establish a "ceiling" price for the Buyer.
- Options Buyers are only exposed to the cost of the premiums.
- The Seller (Writer) of an Option assumes all the risk.