Published on EBF 301: Global Finance for the Earth, Energy, and Materials Industries (https://www.e-education.psu.edu/ebf301)

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

Lesson 10 Introduction

Overview

In Lesson 9, we focused on “futures” marketsand how simple hedges can be accomplished using exchange-traded contracts.Those provide the "building blocks" for the more advanced hedging tools. 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,Spreads and Options

  • 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”) which is the "settlement" price for this arrangement.
  • They are a simpler and less expensive way to hedge price risk as the price difference is what matters and not the price itself.
  • One very important Swap is natural gas “Basis Swap,” which is a market-determined value that represents the difference between the NYMEX Henry Hub contract delivery point for natural gasand other physical (cash) 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 tradedfor 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 theiruses:
    • 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
  • Comprehend the importance of the natural gas Basis Swap and its application in hedging locational price risk.
  • 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

What is due for this lesson?

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 this lesson. For assignment details, refer to the location noted.

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

Lesson Requirements
REQUIREMENT LOCATION SUBMITTING YOUR WORK
Reading Assignment: Chapters 4 & 6 - Errera & Brown Errera & Brown No submission
Mini-lecture:FinancialEnergySwaps Mini-lecture: Financial Energy Swaps page No submission
Mini-lecture: Financial Energy Spread Trading Mini-lecture:Financial EnergySpread Trading page No submission
Mini-lecture: Financial Energy Options Contracts Mini-lecture:Financial EnergyContracts page No submission
Lesson Activity: Black-Sholes Model Exercise Lesson Activity page No submission
Lesson 10 Quiz
Fundamental Factors (on-going)
Summary and Final tasks page
Summary and Final tasks page
Submit through Canvas
Submit through Canvas

Questions?

If you have any questions, please post them to our General Course Questions discussion forum (not e-mail), located under Modules in Canvas. 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.

Reading Assignment: Lesson 10

Reading Assignment:

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.

Mini-Lecture: Financial Energy Swaps

Swaps represent exchanges of payments between two parties. They are financially settled and no physical commodity is delivered or received by either party. They represent a substitute for the futures contracts but rely on NYMEX pricing to establish the financial arrangement for the swap contract. Similar to a NYMEX contract, the elements of a Swap contract include the commodity, location, date, and price.

We use the phrase “fixed-for-floating” Swap to signify the prices agreed to by both parties in the contract. The “fixed” price is always the current market price. It is the price known at the time the deal is struck. The exchange of payments will occur when the NYMEX settlement price is known. We refer to this settlement price as the “floating” one since it is not known until the contract’s last trading day and “floats” with each day’s trading until then. The difference between the two represents the amount of payment due one party or the other.

For example, as of this writing, the December, 2015 NYMEX crude oil contract is trading $44.85. If I bought a Swap, I would be setting my contract price at $44.85. On November 20th, 2015, this contract will settle, and the difference between my $44.85 and the NYMEX Final Settlement price that day, will be the amount exchanged between me and my counterparty. If the contract settles at $45.35, since I bought the Swap, I would be selling it back at that price for a profit of $0.50 and, my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $44.35, I would be selling the contracts back at a loss of ($0.50) and I would pay my counterparty $0.50 per contract, or $500. The calculations are the same as those shown in Lesson 9's hedging spreadsheet.

The advantage of using Swaps for hedging is that you can achieve the same price protection without actually having to buy or sell NYMEX contracts. And, you can work with Brokers either by phone ("Voice" Brokers) or through an electronic trading platform such as "The Intercontinental Exchange (ICE)".

In a previous lesson and, in the textbook, we discussed the fact that physical entities wishing to hedge must take a position in the financial market which is the opposite of their physical position. For instance, a crude oil producer is "long" the commodity. Therefore, in order to execute a proper hedge, they must go "short" in the financial derivative they choose. In Lesson 9, I presented how the physical and financial prices interact in a hedge. The same applies to Swaps as to the NYMEX contracts themselves.

Key Learning Points for the Mini-Lecture: Financial Energy Swaps

  • “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 and other natural gas trading points in North America.
  • For Basis Swaps, the "fixed" price or, "known" is the current market price which can be obtain through electronic platforms such as NYMEX Clearport or ICE. In addition, some brokers will give quotes over the phone. The "floating" price becomes known when the NYMEX contract for the particular month settles and the monthly index ("postings" we addressed in Lesson 5) for the cash location is published. This is known as the "actual" or "settlement" Basis and represents the other value in settling the Swap.

The following Mini-Lecture is a summary of the points presented above.

EBF 301 Lesson 10 Swaps
John A. Dutton e-Education Institute

Mini-Lecture: Financial Energy Spreads

“Spread” trading can be used for hedging purposes or purely for trading (“arbitrage”). This involves using price differences in futures or forwards based upon time differences, locational differences and inter-commodity relationships.

In spread trading, futures or forwards can be used to achieve the desired results. A buy/sell is offset by a corresponding sell/buy. Examples of the types of spreads are:

  1. Time Spread (often called a “storage” spread)
    • Buy a natural gas contract in May/sell it in January
    • Buy a heating oil contract in April/sell it in December.
  2. Locational Spread
    • Buy NYMEX crude (WTI) contract/sell Brent (North Sea) crude contract
    • Buy NYMEX Henry Hub natural gas/sell a different cash market Hub ("Basis" value)
  3. Inter-commodity Spread – Buy/Sell differing but related commodities
    • “Crack” Spread
      • Buy crude oil/sell heating oil or gasoline (HO/RBOB is “cracked” from CL)
    • “Frack” Spread
      • Buy natural gas/sell Propane (midstream natural gas companies process natural gas into Propane and other NGLs)
    • “Spark” Spread
      • Buy natural gas/sell electricity (electric generators can use natural gas to produce power)

In addition to traders who are merely interested in price movement to make money, commercial entities can use Spreads to hedge their price risk. For example, as mentioned above, a crude oil refiner can buy crude contracts (hedge price of feedstock) and sell heating oil and unleaded gasoline contracts (refined output) to establish a profit margin or “crack” spread. This hedge is illustrated in the spreadsheet, "EBF-301 Lesson 10 refinery hedge.xls" found in the Canvas Modules under Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options.

The following Mini-Lecture summarizes the points presented above.

Key Learning Points for the Mini-Lecture: Financial Energy Spreads

  • 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 together for hedge purposes (reduce price risk) or outright trading (speculate on price spread movement).
EBF 301 Lesson 10 Spreads
John A. Dutton e-Education Institute

Mini-Lecture: Options Contracts

Car insurance is a good example of an Option, specifically, a "Call" Option. A premium is paid and the insured has the right to “call” their insurance agent in the event of an accident. The “price” they will have to pay for the damages is limited to the amount of the deductible (“strike price”). The term is usually one year, and if no claim is made, the “option” expires worthless (i.e. – no payout is made by the insurance company since no claim was made). The insured’s maximum exposure is the deductible, thereby establishing a “ceiling price.” And, the premium is calculated using complicated mathematical models (actuarial tables, statistics & probabilities).

Energy options are very similar in nature. As with most financial derivatives, they can be used for hedging price risk or for outright trading. One key difference is that Options represent the Buyer’s right, but not the obligation, to buy or sell futures/forwards contracts. The Options contracts themselves are not futures or forwards contracts but rather a right to buy or sell those contracts. They are traded on the Exchange as well as over-the-counter. And, the Buyer is under no obligation to purchase or sell the underlying commodity contracts if the pricing makes no sense.

Key Learning Points for the Mini-Lecture: Options Contracts

While watching the Mini-Lecture, keep in mind the following key points and questions regarding Energy Risk Hedging Using Options Contracts:

  • Options give the Buyer the right but not the obligation to buy or sell financial energy contracts at some point in time in the future at a set volume and price. They are traded on both the Exchange and over-the-counter markets.
  • They are much cheaper than outright contracts or Swaps in that premiums usually represent only a fraction of the face value of the underlying contracts.
  • As a result, a substantial amount of contracts can be “controlled” relatively cheaply.
  • Options contract components list the commodity, volume, date, price ("Strike"), and premium to be paid.
  • A “Call” option gives the Buyer the right to buy contracts at a fixed price, which creates a maximum, or “ceiling price.” These are mostly used by consumers of the energy commodity wishing to cap their price risk exposure.
  • A “Put” option gives the Buyer the right to sell contracts at a fixed price, which creates a minimum or “floor price.” These are mostly used by producers of the energy commodity wishing to limit their downside price risk.
  • Options values are calculated using algorithmic models.
  • The most popular model is the Black-Scholes Model.
EBF 301 Lesson 10 Options
John A. Dutton e-Education Institute

Components and Types of Options Contracts

The components of an Options contract are:

  • option type (call/put)
  • commodity
  • date
  • strike price (price at which the contracts can be bought or sold by Buyer)
  • premium

Option types are:

  • “Calls” – these give the Buyer the right but not the obligation to buy the underlying financial energy contracts should the market price exceed the “strike price” of the Option contract. In that case, the Buyer would “call” the Seller of the Option and request the contracts.
  • “Puts” – these give the Buyer the right but not the obligation to sell the underlying financial energy contracts should the market price fall below the “strike price” of the Option contract. In that case, the Buyer would “put” the contracts to the Seller of the Option, who must purchase them.

The Buyer of an Option’s exposure is merely the cost of the Option, i.e., the Premium. They will never pay more than that. On the other hand, the Seller, or “Writer,” of an Option bears all the risk and is exposed to any price movement above the strike price of the Call Option, and below the price of the Put Option.

One of the main advantages is that, since only a premium is paid up front, the Buyer of the Options can control a large amount of contracts for a small price. For example, with a Call Option, they are not buying the underlying contracts outright, but are buying the right to purchase them at a set price (“strike price”) if necessary.The Buyer could have the right to buy 100 contracts and only have to pay the premium for the Option and not pay the total cost of 100 contracts.

So, who would use Options contracts for hedging? Let’s take a crude oil Refiner as an example. The company is concerned about rising crude oil prices. But rather than go out and buy hundreds of futures contracts and lock-in the price now, they decide to purchase a Call Option at a strike price that limits their exposure to rising prices. In doing so, they establish a maximum, or “ceiling,” price. So, for December, 2015, they buy a crude oil Call Option at a Strike price of $50.00 since the current price is $45.00. If December prices remain below $45.00, the refiner does nothing and is out only the premium. However, should December prices exceed $50.00, the refiner calls the Option Seller and requests the number of crude oil contracts agreed upon at the $50.00 Strike price (or, they could ask for payment of the price difference in the market). In this scenario, the refiner will never pay more than $50.00 for their crude supply. And, they capture all the downside of prices should the market fall.

On the flip side, let’s consider the crude oil Producer who is worried about falling prices, so they enter into a Put Option to establish a “floor” price. For December, they choose a $40.00 Strike price, thus establishing the lowest price at which they will have to sell their crude oil. Should prices fall below that level, they will contact the Options Seller and request their right to sell the underlying financial contracts at $40.00. Should prices remain above $40.00, the producer would do nothing and be out only the price of the Option (premium). In this way, the producer can reap all the benefits of higher prices regardless of how high they go.

If not exercised, Options expire worthless. And, Options are time-sensitive. The closer to the expiration date, the less value the Option has (less risk exposure with less time remaining).

There are numerous mathematical models that are used to determine Options premium values. The most well-known is the Black-Sholes Model. It is an extensive algorithm that only needs a few inputs to calculate an Option’s value.

  • Asset Price (current market price)
  • Strike price (Buyer’s desired price)
  • Days to Expiration (of the underlying commodity contract)
  • Volatility of the underlying contract (available market data)
  • Interest Rate (This is the opportunity cost of paying the premiums upfront vs. investing the cash in something else. The Federal Reserve’s Prime Rate is normally used.)

A spreadsheet with the Black-Sholes Model and sample inputs can be found in the Canvas Modules under Lesson 10: Advanced Financial Derivatives - Swaps, Spreads, and Options.

Lesson Activities

Black-Sholes Model Exercise Activity

In Canvas, under Lesson 10, you will find a spreadsheet called the Lesson 10 Options Model. It will give you a sense as to how the different inputs affect the put and call prices for an option. Please play around with a couple of examples (you can use commodities and/or stock options)). No need to submit anything.

Fundamental Factors

The Fundamental Factors activity is due as usual this week, at 11:59 pm on Sunday, and is worth 30 points on the EBF 301 grading scale. Please refer to the Fundamental Factors Instructions [1] for additional information and grading rubric.

Submitting Your Work

Black-Sholes Model Exercise: No need to submit anything.

Fundamental Factors: Submit your work as a single word processed document to the Lesson 10 Fundamental Factors Activity in Canvas.

Summary and Final Tasks

Key Learning Points: Lesson 10

  1. Swaps are exchanges of payments between two parties and are strictly financial in nature.
  2. They can be used in lieu of futures contracts and are, in fact, “forward” contracts.
  3. They are non-exchange traded instruments.
  4. They can be used for hedging or outright trading.
  5. “Fixed-for-floating” Swaps use current NYMEX market prices and final settlement prices to determine the balance of payments under the agreements.
  6. Spreads represent the price difference between commodity locations, relationships and timeframes.
  7. They can also be used for hedging or outright trading (arbitrage).
  8. The most common types of Spreads are location, time (storage) and, inter-commodity.
  9. Inter-commodity Spreads can be by oil refiners, midstream natural gas companies and, electricity generators to lock-in margin.
  10. Options are a simple and less costly way to hedge price risk than the outright purchase or sale of energy financial contracts.
  11. They give the Buyer the right but not the obligation to buy or sell the underlying energy commodity contracts at the “strike price.”
  12. The Seller, or “Writer,” of the Option assumes all risk.
  13. Options can be used for hedging or outright trading.
  14. 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.
  15. 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.
  16. The Black-Sholes Model is the most popular Options Valuation Model.

Over the past few weeks, you have been researching various Fundamental Factors that can be used to aid in making trading decisions. The other type of information, used by "Day Traders," is "Technical Analysis." In the next lesson, we will get an elementary overview of TA.

Quiz and Activities

Log onto Canvas and complete the Lesson 10 Quiz

Submit your weekly Fundamental Factors

Reminder - Complete all of the lesson tasks!

You have reached the end of this lesson. Double-check the list of requirements on the first page of this lesson to make sure you have completed all of the activities listed there before beginning the next lesson.


Source URL: https://www.e-education.psu.edu/ebf301/node/544

Links
[1] https://www.e-education.psu.edu/ebf301/680