Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options - Hidden

Overview

In Lesson 9, we focused on the “futures” markets and how simple hedges can be accomplished using exchange-traded contracts. Here, we will address the “over-the-counter,” non-exchange traded markets, or “forward” contracts. Keep in mind that NYMEX Exchange contracts are referred to as “futures.” We will also cover financial “spreads” whereby traders take advantage of price differences based on location, time, or inter-commodity relationships. Finally, we will deal with financial Options which are a simpler and less costly form of hedging vs. the financial derivative contracts themselves.

Key Learning Points – Energy Risk Hedging Using Swaps and Spreads

• Exchange-traded energy contracts are known as “futures,” whereas non-exchange traded contracts are known as “forwards."
• These are traded on electronic trading platforms or over the phone with licensed Brokers.
• “Swaps” are exchanges of payments between two parties. They are strictly financial. No physical exchange of the commodity takes place.
• One party to the transaction agrees to pay a current market price (“fixed”) while the other agrees to pay a price in the future (“floating”).
• They are a simpler and less expensive way to hedge price risk.
• One very important Swap is a “Basis Swap,” which is a market-determined value that represents the difference between the NYMEX Henry Hub contract delivery point and other natural gas trading points in North America.
• Spreads are merely price differences between commodities that are interrelated somehow, have differing locations, or represent different months of the same commodity.
• They are traded for hedge purposes (reduce price risk) or outright trading (speculate on price spread movement).
• Energy Options are yet another, more simple way to hedge price risk. They are less expensive than the outright purchase or sale of the underlying contracts. We will cover the types and their uses:
  • Call Options
  • Put Options
  • Hedging with Options

Learning Outcomes

At the successful completion of this lesson, students should be able to:

• Understand the following financial derivatives and their uses:
  • Swaps
  • Spreads
  • Options
• Apply advanced financial derivatives to energy commodity hedging
• List the components of an Options contract
• Be familiar with the Black-Scholes Model for Options valuation
• Know the inputs to run the B-M model spreadsheet

What is due for Lesson 10?

This lesson will take us one week to complete. There are a number of required activities in this module. The chart below provides an overview of the activities for Lesson 10. For assignment details, refer to the location noted.

All assignments will be due Sunday, 11:59 p.m. Eastern Time.

Questions?

If you have any questions, please post them to our Questions? discussion forum (not e-mail), located under the Communicate tab in ANGEL. The TA and I will check that discussion forum daily to respond. While you are there, feel free to post your own responses if you, too, are able to help out a classmate.