INTERNATIONAL RISK MANAGEMENT

Discuss the general use of energy futures contracts in risk management

companies can use?

Executive Summary
The study makes the analysis of the general uses of the energy future contracts in the risk
management and how they are used by the companies. The study reveals that use of the
futures contracts will reduce the expected cash flow for the corporation so that the risk averse
will increase the optimal hedging of the company. There are also varieties of the factors that
will attribute to the volatility in the markets and they are commodity and the market
fluctuations, the changes in the currency exchange rates, the imbalances which is prevalent in
the supply and demand, the trade agreements which is present among the producing and the
consuming nations.
The application of the contracts and how they are helpful is also assessed and they are
revealed. The main advantage is that the participation of the futures contract will remove the
uncertainty of their future price of an item. The locking price which they are able to buy or
sell for a particular item will make the company to eliminate the ambiguity that they have
with the expenses and the profits that they are expecting. This is explained in two different
sections where the review of the literature is done on the futures and the opinion of many
authors in this area and later on the application of contracts.

Table of Contents
Executive Summary..................................................................................................... 2
Introduction:.............................................................................................................. 4
Literature review:........................................................................................................ 5
Application of contracts:............................................................................................... 7
Conclusions:.............................................................................................................. 8
References:............................................................................................................... 9

Introduction:
The study makes an analysis of how the energy futures contracts can be used in the
management of the risk by the companies. The management of the risk is the set of the
activities that is done for the assessment of the corporations risk exposure to the different
sources of the risk and which can be hedged by making use of the financial instruments and
other kinds of contracts. The corporation has made the decision for management of the risk
and the implementation of the issue of the hedging is also picked up so that they deal with the
financial contracts for the implementation for hedging purposes. (Blanco, 2010)There are
different types of the risk that is associated with the hedging when the contracts are designed.
The operating risk includes many types of the risk like the rate risk, the inflation rick,
currency risk and the commodity price risk. There are different contracts which are traded in
the financial markets which will address these kinds of the risk. (Kleindorfer, 2012)
The corporation consumes and produces the commodity and this will be exposed to many
kinds of the quantity and also the price risks. The financial markets will employ these risks
and employ many kinds of the options in energy markets so that the options have gained
more popularity. The significant distinction is made with more respect to the futures Vs the
options. The options are very costly but on the flipside they will reduce the risk on the
downside. (Kolos, 2012) The inability that exists in the standard contracts will help in the
capturing the structural characteristics of the energy deals and also the assets. This can be
managed effectively with the more relevant price risks and leads to the increase in the usage
of the complex energy contracts. The most important contracts is that they are something that
cannot be addressed with standard contracts and they have very sharp hike in the process of
pricing. This is one of the main reason for the spikes in the inelasticity in demand which will
increase the demand response and gain more popularity among the energy retailers. (NFA,
2012)
The risk metrics has much volatility which is calculated on the basis of the risk factors and
this is vital in pointing out the risk metrics which will show more limited number of the risk
factors mostly on the basis of the foreign exchange, the equities and also the interest rate.
The energy firms must also use volatility which is customized with their own portfolios. This
is very much necessary for finding up of historical prices and also the commodity risks that
they face with the accepted methodologies. The following will measure the effectiveness of
the hedging program and the risk of fixed assets as well as the investment projects. This will

also assess risk management reports for the senior management so that they can better
provide the understanding in the overall risk profile of the firm. (Till, 2012)

Literature review:
There are numerous number of the factors which will increase the risk in the energy future
contracts and they are mainly the lack of proper information about the issues that requires the
more technical support with respect to the performance and the energy saving technologies.
There must be uncertainty in the energy prices and this will subsidize the energy prices so
that they will be able to undermine the incentives for the EE projects. (Blanco, 2010) There
will be high exchange rate risk that is associated with this project so that this is sold only in
the international markets. The quantity and the price which exists as their relation to the
management of risk with commodity markets is explained more in the literature.
(Kleindorfer, 2012)
The literature that mentions about the futures markets is considered as the simple portfolio
and thus it will contain commodity inventory and their short position in their future contracts.
There is a hedge which is derived assuming the quantity that can be hedged with the output
price risk which is considered more significant and thus the decision is more about the
optimal size if position of futures. (Kolos, 2012) The main aim is to maximise the gross
returns which is subjected to the risk on the basis of the variance. The result will make the
futures position more identical and reduces the variance in the returns so that the future price
is unbiased and they forecast this terminal price with the completion of the hedge. The
problem is mentioned more specific to the joint decision that is taken with the quantity and
the size of their futures position which will minimise the returns that is obtained with the
ration of the covariance of futures and also the cash prices with the variance of the future
prices. (NFA, 2012)
There are other kinds of the models that is developed so that they consider this optimal
position in the futures will take the account of price and this will yield the risk in the joint
way. There are many questions which will arise in a multi period set up. How to hedge
when the funds that is available is limited and how to support the hedging program when the
mark to market will give rise for more additional risks. It is the natural extension which
will consider the position in the option contracts which is generally a part of the portfolio. In

case if the model is incorporating the options markets then their mean variance framework
and their options framework, the options premiums will be unbiased and this makes the
options to be a redundant hedging instruments. The optimal hedging strategy will involve
only futures. This is considered as the result of obtaining normally distributed prices (which
usually allow the negative pricing also). (NFA, 2012)
The distribution in the returns is skewed and this will be considered as the right option
contracts which will enter the optimal portfolios. The restrictions of the hedging are only for
the options which will discuss the optimal hedging with the value at the risk in the options
and the futures that is considered. The prices of the futures are considered to be the unbiased
predictors of the spot prices and this will arrive at more similar results which will concern the
relevance of correlation that exists with the quantity and price so that they influence the other
parameters like the choice that exists between the options and the futures in the hedging.
(Till, 2012)
If the hedging is considered as costly then the use of the futures contracts will reduce the
expected cash flow for the corporation so that the risk averse will increase the optimal
hedging of the company to no hedging and also to acquire options so that they will be able
acquire the options or to replace the options with the future contracts. There are variety of the
factors that will attribute to the volatility in the markets and they are commodity and the
market fluctuations, the changes in the currency exchange rates, the imbalances which is
prevalent in the supply and demand, the effect of the weather on the yield of the crop, the
speculative influences, the trade agreements which is present among the producing and the
consuming nations, the political unrest in the producing nations, and the changes that is seen
in the governmental and also in the agricultural programs and the energy policies.
(Kleindorfer, 2012)
It was the New York Mercantile Exchange (NYMEX) which provided the energy companies
with certain kinds of the tools which will help the power industry to secure and reliable risk
management tools with the series of the electricity future contracts which is fashioned to meet
the needs and also practices of the power industry. The buying and also the selling of these
future contracts with their related options contracts makes the industry much needed price
reference and also a risk management tool. In the power industry the sales is normally over
$250 billion and the increase increases cannot be passed to the customers so that the pricing
resources that is used for the generation of the electricity is significant. The coal has become

the more strong market forces in US and they are very volatile. This makes the electric
utilities to no longer eager to enter into the long term coal supply once which was their
established norm. There is now more preference for the short term and also the more price
flexible contracts so that they rely more on the cash market purchases than on the power
producers who will try to reduce their inventory levels. The coal futures will now provide the
electric power industry with another set of the risk management options and also offers them
the risk management tools. (Kleindorfer, 2012)

Application of contracts:
The futures are vital derivatives that are used for the hedging of the risk. This is normally an
arrangement between two parties for the either buying or selling an asset at the particular
period of time in the future at a particular price. The main reason behind this is that the
companies and the corporations will be using the future contracts for offsetting the risk which
will expose and limit them from the fluctuations in the price. There is an ultimate goal for the
investor to use their future contracts so that they can perfectly hedge their risk. This is often
impossible in the real life since the individuals try to neutralise their risk as much as possible.
Example: the commodity that is hedged will not be available for the futures contract so that
the investor will buy the futures contract which will closely follow the movements of that
particular commodity. (Kleindorfer, 2012)
The futures contract is very much useful in limiting the risk exposure which the investor has
in their trade. The main advantage is that the participation of the futures contract will remove
the uncertainty of their future price of an item. The locking price which they are able to buy
or sell for a particular item will make the company to eliminate the ambiguity that they have
with the expenses and the profits that they are expecting. (Blanco, 2010)
Who shall use the future contracts?
There are two main reasons for the using of the future contracts

To hedge the price risk

To speculate the change in the price

A hedger is the person who owns or plans to purchase their inventory of the commodity and
they wish to reduce the risk that is associated with their ownership. The hedgers will make

their purchases and the sales solely for the purpose of establishment of a known price level in
advance for things that they buy later or sell in the cash market. This is done by taking more
equal and opposite position in the case of the futures market than in the case of the cash
market. The price for the commodity will fluctuate and the hedger will be protected since the
gains in the one market will be offset with the losses in the other market regardless o the
direction in which the price is moving. The hedgers willingly give up their opportunity so
that they shall benefit from the change in the prices and achieve the protection of
unfavourable price changes. (Blanco, 2010)
The speculator on the other hand will be taking the risk willingly and they wish to relinquish.
The speculators will take position on their expectations of their future price and their
movement which will often have no intention of making or taking the delivery with respect to
the commodity. They buy it when they anticipate the rise in the prices and they sell it when
they anticipate the decline in the prices. The speculator gives the vital function in the futures
market since without him the market will not be liquid and the protection of the prices will be
sought by the hedger which is very costly. (Kolos, 2012)

Conclusions:
Unlike the stock which will represent the equity in the company and one that can be held for
the long time the futures contract will have their finite lives. This is since they are mainly
used for the hedging of their commodities. The hedging of the commodity will use the price
fluctuation risks or taking advantage of the movements in the prices than for buying and the
selling of the commodities. The word contract is used since the futures contract will require
the delivery of the commodity in the stated month and the future contract unless they are
liquidated before they expire.
The buyers in the futures contract will agree on the fixed purchase price so that they buy the
underlying commodity from the seller at the expiry of the contract. In the industry the
disagreements may arise from one time to the and the first step for the resolution is to assure
that they have made a very reasonable effort to reach to a settlement with the direct
discussions that they make with the other party. The conclusion can thus be made that the
valuing the instruments is completely on the basis of the trading team and also on the
imposition of the strict position limits in their electronic trading systems. The assignment
gives more emphasis of the future contracts and how they are used in the energy industries

and how their uses are normally spread. This will normally emphasise on the challenges that
are available for the trader and they attempt to navigate with their dynamic flows in the
commodity market and also in the prevailing risk environment.

References:

Blanco, C. (2010). Value at risk for energy: is var useful to manage energy price risk?
Financial Engineering Associates, 12 - 34.

Kleindorfer, P. R. (2012). Risk management for energy efficiency projects in

developing countries. Development policy, statistics and research branch Working
paper , 33 - 56.

Kolos, S. P. (2012). Risk Management in Energy Markets. Journal of Finance , 22 45.

NFA. (2012). Security Futures - An introduction to their uses and risks. NFA
information and resources , 22 - 45.

Till, H. (2012). Case Studies and Risk Management in Commodity Derivatives

Trading. EDHEC Business School , 34 - 56.