Commodity Risk Management - PowerPoint

							Commodity Risk Management




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               Physical Contracts
• Volume Types
  Firm - seller or buyer has legal recourse if volume not
    delivered or taken
  Interruptible or Swing - seller nor buyer obligated

• Key Terms of Contract
  buyer
  seller
  price
  quantity
  receipt/delivery point/title transfer point
  time
  terms and conditions
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Energy components of floating prices or fixed prices
• Index Reference Point such as NYMEX “Henry
  Hub” for Natural Gas
  WTI (West Texas Intermediate-Cushing)
  or Brent for Crude Oil
  plus
• Basis or Location Differential from Index Pricing
  Point
Any or all components can be fixed or floating.

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  Financial Market Terminology
Derivative:
 A Trading Instrument: Value is determined
 from one or more physical commodities
 and/or financial securities underlying the
 derivative.
Underlying Commodity or Security:
 The physical commodity or financial
 security from which a derivative obtains its
 value.
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Leverage:
  The effect of magnifying the outcome of an
  investment through use of borrowed funds.
  Example: Price at Purchase = 100
              Price at Sale Year Later = 120
              Equity % Gain = 20%
              Unlevered Gain = 20%
  If borrowed 50% at 10% Interest
  Gain = 120 - 100 - 5 = 15
  Original Equity Investment = 50
  Equity Gain % = 30%
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Hedging:
  In general, the term hedging is used when describing
  entering a transaction with the intent of offsetting risk
  from another related transaction.
  Examples:
     insurance for fire, business interruption
  In commodities and securities markets, a hedge is a
  transaction entered into for the purpose of protecting
  the value of a commodity or security from adverse
  price movement by entering an offsetting position in
  a related commodity or security.

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Futures Contracts:
• Standardized: Each contract represents the same
  quantity and quality of the underlying physical
  commodity, valued in the same pricing format to be
  delivered and received at the same delivery location.
• The date of delivery and receipt is the same for all
  contracts traded.
• Futures contract is a tradable document which
  entitles the buyer of the contract to claim physical
  delivery of the commodity from the seller at the
  contract delivery point at a specified date in the
  future, and entitles the seller to deliver the physical
  commodity to the buyer under the same conditions.
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Value:
 Because a futures contract is a tradable,
 (can be bought and sold in the open
 market), its value changes as the supply and
 demand for the futures contract changes.
 The price of a futures contract is derived
 from the price of the underlying commodity
 which it represents and thus is a derivative.


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Exchange:
 No cost swap of physical commodity from
 one physical location to another location
 without actually moving the commodity.

Futures Liability:
  Unlimited upside or downside.



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Financial Swaps:
                    Fixed Price
       Buyer                        Seller
                   Floating Price

 Buyer trades fixed receives floating.
 Seller trades floating receives fixed.
 At the time of the trade, the two positions are
 considered to be of equal value.
 Used frequently for currencies, commodities
 and interest rates.
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Futures Swaps:
  Performs almost the same function as a
  futures contract with the exception that,
  after expiration of the futures contract, there
  is a financial settlement for futures swaps
  (exchange of payment), as opposed to a
  physical settlement (making or taking
  delivery if an open position is held through
  expiration) in the case of actual futures
  contracts.
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                    Options
American Option:
  Tradable contract between two parties giving the
  buyer of the option the right, but not the
  obligation, to purchase or sell a given commodity
  or security at a specified price at any time up to
  and including the expiration of the option contract.
European Option:
  Identical to American except may only be
  exercised at expiration of contract.
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Option Contracts: Two Types
• Calls (American):
  Grants the buyer of the option the right, but not
  the obligation, to buy the underlying commodity
  or security from the seller of the call option at a
  specified price (called the strike price) at any time
  up to and including the expiration of the option.
  The seller of a call option is obligated to sell the
  underlying commodity or security to the buyer of
  the call option, at the strike price, at any time, up
  to and including the expiration date.

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• Put Option (American):
  Grants the buyer of the option the right, but not
  the obligation, to sell the underlying commodity or
  security to the seller of the put option at the strike
  price at any time up to and including the
  expiration of the option.
  The seller of the put option is obligated to buy the
  underlying commodity or security from the buyer
  of the put option, at the strike price, at any time,
  up to and including the expiration date.


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                 Buying a Call

Profit



                  Strike Price
 Cost
  of
 Call



                 Price of Underlying Commodity or Security




         Buyer of Call Option Profits if Prices Rise         15
                   Selling a Put

Profit


  Put
Premium
Received
                     Strike Price




                  Price of Underlying Commodity or Security




           Seller of Put Option Loses if Prices Fall          16
Costless Collars

  The simultaneous selling of a call option at an
  above market strike price and the buying of a put
  option at a below market strike price such that the
  premium received on the sale of the call option
  equals the price paid for the put option.

  Has the effect of locking in a range of prices with
  a floor and ceiling in which you are guaranteed to
  receive for your commodity or security at
  expiration.
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Option Risk and Liability

  The buyer’s risk is limited to what it paid
  for the option (option premium), but the
  seller’s liability is theoretically unlimited
  for the duration of the option’s life.




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Exercising an Option

 Process where the buyer of an option (either
 a put or a call) elects to execute its given
 right to either buy (call) or sell (put) the
 underlying commodity or security from or
 to the option seller at the strike price.




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Option Valuation
  The price of an option is called its premium.
  Option Premium is paid by the buyer to seller at
  time option contract is written.
  Option Premium: Two Components
  • Intrinsic Value: Positive difference, if any,
    between the strike price of the option, and the
    price of the underlying commodity or security
    for which option is based on.
  • Time Value: Remaining Value other than
    intrinsic.
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An option which has intrinsic value is called
an in the money option.

An option which has no intrinsic value is
called an out of the money option.




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Black Scholes Valuation
  Used to Value Options: Quantified probability
  that the strike price of the option will be in the
  money at expiration.

  Four Main Valuation Parameters:
  1. relationship between the strike price of
     the option and the current price
  2. time remaining until option contract expires
  3. level of interest rates and dividend (if any)
  4. estimated volatility of the underlying
     commodity or security
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Volatility

  Price change movement measured as a
  percentage of stock price based upon the
  standard deviation of historical prices.

  If a commodity or security is extremely
  volatile, the probability is higher that an
  option with an out of the money strike price
  will expire with intrinsic value (in the
  money).
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