Lesson 10 Introduction

Overview

In Lesson 7, we focused on “futures” markets and 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 gas and 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 traded for hedge purposes (reduce price risk) or outright trading (speculate on price spread movement).
• Energy options are yet another, simpler way to hedge price risk. They are less expensive than the outright purchase or sale of the underlying contracts. We will cover the types of energy options and their uses:
  • call options
  • put options
  • hedging with options

Learning Outcomes

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

• explain 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;
• outline the inputs to the Black-Scholes model for options valuation

What is due for this lesson?

This lesson will take us one week to complete. The following items will be due Sunday at 11:59 p.m. Eastern Time.

• Lesson 10 Quiz
• Lesson 10 activities as assigned in Canvas

Questions?

If you have any questions, please post them to our General Course Questions discussion forum (not email), 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.