Derivatives

Overview Derivatives
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Contents
Contents
Contents ................................................................................................................................................ 2
DERIVATIVES ........................................................................................................................................... 6
What are Derivatives?......................................................................................................................... 6
Why have Derivatives?........................................................................................................................ 7
Who uses Derivatives? ........................................................................................................................ 8
How are Derivatives traded? .............................................................................................................. 8
Open outcry .................................................................................................................................... 9
OTC .................................................................................................................................................. 9
Automated matching systems: ....................................................................................................... 9
Forward contracts: ............................................................................................................................ 11
Futures contracts: ............................................................................................................................. 13
Trading on margin: ............................................................................................................................ 15
Who uses futures contracts? ............................................................................................................ 17
Relationship between cash and futures prices: ................................................................................ 18
Trading strategies ............................................................................................................................. 19
Spread trading................................................................................................................................... 19
Off-setting contracts ......................................................................................................................... 20
Commodity and Energy futures contracts ............................................................................................ 20
Financial futures contracts................................................................................................................ 23
The importance of forwards and futures.......................................................................................... 24
OTC v Exchange traded derivatives................................................................................................... 24
What are options? ................................................................................................................................ 26
Option styles ..................................................................................................................................... 27
Why do holders and writers use options? ........................................................................................ 29
How options work ............................................................................................................................. 29
Strike prices....................................................................................................................................... 30
Swaps transactions ............................................................................................................................... 31
Interest Rate Swaps (IRSs) ................................................................................................................ 32
Currency swaps ................................................................................................................................. 33
Commodity swaps ............................................................................................................................. 33
Equity swaps ..................................................................................................................................... 33
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Supply, demand and the weather......................................................................................................... 34
Weather ............................................................................................................................................ 35
Political/international events ........................................................................................................... 35
Availability and cost of labour........................................................................................................... 35
Production/processing demands ...................................................................................................... 35
Sugar and Wheat........................................................................................................................... 36
Aluminium ..................................................................................................................................... 36
Commodities markets ........................................................................................................................... 36
What are they? ................................................................................................................................. 36
What are hard and agricultural commodities? ................................................................................. 36
How do the physical markets work? ................................................................................................. 36
Settlement details ............................................................................................................................. 37
Types of commodities ........................................................................................................................... 37
Metals ............................................................................................................................................... 37
Base metals ................................................................................................................................... 37
Strategic/minor metals ................................................................................................................. 37
Precious metals ............................................................................................................................. 38
Softs .................................................................................................................................................. 38
Grains and Oilseeds........................................................................................................................... 39
Grains ............................................................................................................................................ 39
Oilseeds ......................................................................................................................................... 39
Livestock........................................................................................................................................ 39
Fibres ............................................................................................................................................. 39
Energy markets ..................................................................................................................................... 39
Petroleum and its products .............................................................................................................. 40
Electricity markets ............................................................................................................................ 40
Base: .............................................................................................................................................. 42
Peak:.............................................................................................................................................. 42
Off Peak ......................................................................................................................................... 42
Day-ahead market:........................................................................................................................ 42
Real-Time Energy Market.............................................................................................................. 43
Intra-day market: .......................................................................................................................... 43
Season contracts ........................................................................................................................... 43
Quarter contracts .......................................................................................................................... 43
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Quarterly Peak Load Futures Contracts ........................................................................................ 43
Month contracts ........................................................................................................................... 44
Monthly Base Load Futures Contracts .......................................................................................... 45
Balance of the Month (BOM/BALMO) .................................................................................................. 46
Weather Markets .................................................................................................................................. 47
In Contrast to Weather Insurance .................................................................................................... 48
Weather Futures and Options on Futures ........................................................................................ 49
Measuring Daily Index Values ........................................................................................................... 49
Measuring Monthly Index Values ..................................................................................................... 50
Temperature Contracts ................................................................................................................. 51
Degree-day swaps ......................................................................................................................... 51
Degree-day options ....................................................................................................................... 51
Degree-day collars ........................................................................................................................ 51
Degree-day straddles .................................................................................................................... 51
Digital options ............................................................................................................................... 51
Dual-trigger options ...................................................................................................................... 51
Compound options: ...................................................................................................................... 51
Guaranteed forecast: .................................................................................................................... 51
Snow Futures ................................................................................................................................ 52
Hurricane futures .......................................................................................................................... 52
Other energy markets ........................................................................................................................... 53
Transport markets................................................................................................................................. 53
Shipping bulk markets........................................................................................................................... 53
Why are there markets? ................................................................................................................... 53
Dry bulk cargoes – The Baltic Exchange ............................................................................................ 53
Air cargo markets .............................................................................................................................. 54
Why are there markets? ............................................................................................................... 54
Delivery/settlement methods ............................................................................................................... 54
Spot, cash and physical settlement and delivery .............................................................................. 54
Spot transactions: ......................................................................................................................... 54
Physical settlement ....................................................................................................................... 55
Cash settlement ............................................................................................................................ 55
In store/Ex store............................................................................................................................ 56
Ex store.......................................................................................................................................... 56
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Free On Board (FOB) ..................................................................................................................... 56
Cost-Insurance-Freight (CIF) ......................................................................................................... 57
Free Along Side (FAS) .................................................................................................................... 57
Alternative Delivery Procedures (ADPs) ....................................................................................... 57
Exchange of Futures for Physicals (EFPs) ...................................................................................... 57
Appendix ............................................................................................................................................... 57
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DERIVATIVES
What are Derivatives?

“A derivative is a financial contract, between two or more parties, which is derived from the future
value of an underlying asset.”
The original trading of derivatives involved a commodity such as rice, tulip bulbs or wheat as
the underlying asset. Today, some underlying assets are still commodities but in addition
almost any other financial measure or financial instrument can be used. For example there
are derivatives based on debt instruments, interest rates, stock indices, Money Market
instruments, currencies and even other derivative contracts like Weather, Electricity!
There are four main types of derivatives traded today which:
 Forward contracts
 Futures contracts
 Option contracts
 Swap transactions
“A forward contract is a transaction in which the buyer and the seller agree upon the delivery of a
specified quality and quantity of asset (usually a commodity) at a specified future date. A price
may be agreed on in advance or at the time of delivery.”
Example: It is early September and you decide you want to buy a new car. You select the
type of car you want and go to your local dealer. At the dealer’s showroom you decide on
the exact specification of your car – colour, engine size, wheel etc., and more importantly
the price is set. The dealer tells you that if you place the order today and place a deposit,
then you can take delivery of the car in 3 months’ time. If in 3 months’ time the dealer is
offering a 10% discount on all new cars, or the price of the model has increased, it does not
matter. The price you pay for the car on delivery has been agreed and fixed between you
and the dealer. You have entered into a forward contract – you have the right and
obligation to buy the car in 3 months.
You entered into a forward contract. The terms of the deal were privately negotiated with
the dealer and you paid a deposit as a form of collateral that you would honour the
contract. But what would have happened if the car you ordered did not arrive on time or it
was not quite the specification you ordered? You would have to resolve the problem with
the dealer.
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For the more general case of commodities such as food, metals, oil etc contracts with
standard conditions for amount, quality, delivery date etc were introduced in market places
known as exchanges. The contracts traded were known as futures contracts.
“A futures contract is a firm contractual agreement between a buyer and seller for a specified
asset on a fixed date in the future. The contract price will vary according to the market place but it
is fixed when the trade is made. The contract also has a standard specification so both parties
know exactly what is being traded.”
The price of a futures contract is agreed on an exchange floor in a process whereby buyers
and sellers shout their orders and quotes publicly. This means that once a contract is agreed
everyone on the floor knows the price paid. This transparency in futures contracts prices is
one of the main differences between forward contracts where prices are privately
negotiated.
“An option contract confers the right, but not the obligation, to buy (Call) or sell (Put) a specific
underlying instrument or asset at a specific price – the strike or exercise price – up until or on a
specific future date – the expiry date. The price to have this right is paid by the buyer of the option
contract to the seller as a premium.”
“A swap transaction is the simultaneous buying and selling of the same underlying asset or
obligation of equivalent capital amount where the exchange of financial arrangements provides
both parties to the transaction with more favourable conditions than they would otherwise
expect.”
Why have Derivatives?

Derivatives are very important financial instruments for risk management as they allow risks
to be separated and traded. Derivatives are used to shift risk and act as a form of insurance.
This shift of risk means that each party involved in the contract should be able to identify all
the risks involved before the contract is agreed.
It is also important to remember that derivatives are derived from an underlying asset. This
means that risks in trading derivatives may change depending on what happens to the
underlying asset. For
Example, if the settlement price of a derivative is based on the cash price of a commodity
which frequently changes on a daily basis, then the derivative risks are also changing on a
daily basis. This means that derivative risks and positions must be monitored constantly.
Fortunes can be made and lost trading derivatives!
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Who uses Derivatives?
Derivatives are used by a party who is exposed to an unwanted risk and can pass this risk on
to another party willing to accept it. Originally producers of commodities used forward and
futures contracts to hedge prices and therefore their risk.
Suppose you are farmer growing rice or corn and you want to protect the future price of
your harvest against price fluctuations. You can do this by hedging your position. In other
words you sell your crop today for a price which is for a guaranteed amount for delivery of
the crop and payment in the future. If the cash price of your crop at delivery is more than
your guaranteed amount you cannot gain. You have an obligation to fulfil the contract and a
right to receive the agreed delivery price. Any loss or gain in the cash market is offset by a
gain or loss for the futures contract.
However if you had used an option contract you could have bought a contract where
you had the right but not obligation to sell your crop in the future. If the future cash prices
were better than the option price, then you could take advantage of them. Also using an
option limits any losses you may incur. Manufacturers using commodities also use
derivatives to hedge their positions in order to predict and stabilise their production costs.
If commodity producers want to hedge their positions, then who takes on the other
side of the contract? In many cases it could be other hedgers, for example, manufacturers,
or it could be speculators. A speculator takes an opposite position to a hedger and exposes
him/herself in the hope of profiting from price changes to his or her advantage. There are
also arbitrageurs who trade derivatives with a view to exploit any price differences within
different derivatives markets or between the derivative instruments and cash or physical
prices in the underlying assets.
How are Derivatives traded?

Traders are the market players who buy and sell derivatives contracts on behalf of their
clients or on their own account in the financial and commodity markets. There are three
basic ways in which trading can take place. Trading can take place:
 On an exchange floor using open outcry

 Over-The-Counter (OTC)
 Using an electronic, automated matching system such as GLOBEX
Derivatives traders can operate across all the markets buying and selling futures, options,
swaps contracts etc.
In some markets brokers act as intermediaries between traders and clients. Brokers do not
usually trade on their own account but earn commissions on the deals that they arrange.
Traders and brokers both have a number of financial data needs which are provided by Data
Vendors. Data such as:
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 Information on the underlying instruments
 Technical analysis
 Prices from exchanges and contributors
 News
Open outcry
Open outcry involves traders or brokers operating on an exchange floor where they
communicate their deals by shouting at each other and using hand signals. Example: CME
OTC
This method originates from the days when instruments were literally bought over the
counter of a bank, for example. The present day meaning describes markets which have no
specific locations, have fewer rules governing trading and which may be more international
in character. Trading takes place directly between dealers and principals via a telephone and
computer network rather than via a highly regulated exchange floor.
Automated matching systems:

Many exchanges use an automated matching system to extend their trading hours. The
systems are either provided as a joint venture such as GLOBEX, MATIF/SIMEX venture, or
specific to an exchange such as Automated Pit Trading (APT) on LIFFE. The automated
matching systems operate using the same trading rules used for floor trading. They also
offer the advantage of anonymity in trading and so are sometimes known as electronic
brokers.
There are three characteristics of an automated matching system:
 Users send their bids and offers to a central matching system

 The bids and offers are distributed to all other market participants
 The system identifies possible trades based on price, size, credit and any other rules
relevant to the market
The main differences mentioned so far between Exchange traded and OTC derivatives are
summarised in the following table.
Exchange traded OTC
Derivatives available:
Derivatives available: • Forwards
• Futures • Options
• Options • Swaps
Derivatives traded on a competitive Derivatives traded on a private basis and
floor, open outcry individually negotiated
Standardised and published contract No standard specifications although plain
specifications vanilla instruments are common
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Prices are transparent and easily
available Prices are not very visible
Market players must be known to each
Market players not known to each other other
Trading hours are published and 24 hour markets which are less well
exchange rules must be kept regulated
Positions are not easily closed or
Positions can easily be traded out transferred
Few contracts result in expiry or physical Majority of contracts result in expiry or
delivery physical delivery
Contracts can be traded by private Usually used by large corporations, banks
investors etc
The concept of trading forward, that is, buying and selling an asset for delivery at a future
date, originated in the early commodity markets. In principle there are two basic markets in
which trading assets and financial instruments can take place.
These are the:
 Spot, cash or physical markets

 Forward or futures markets
Spot, cash or physical markets:
In these markets, traders buy and sell the actual physical commodity and typically settle the
transaction two business days later for cash. This is why the markets are also known as the
cash markets.
Typically cash or spot trading is OTC but occasionally some commodities such as tea,pepper,
spices are still traded in salesrooms or at auction. Trades are non-standardised and each
deal is individually negotiated specifying a particular delivery date, location, quality and
quantity of commodity.
The parties to the trade must be very clear on the contract terms as there is a degree of risk
involved in all OTC transactions which has to be assessed by both sides. Will the seller
deliver and will the buyer pay on delivery?
As the contracts are private, the specific terms are not reported or made transparent by the
counterparties. However, some exchanges, market-makers and official organisations quote
spot prices for physical delivery two business days from the quote date.
It is important to remember that these cash or spot prices provide a guide only – they are
not necessarily the prices used for a transaction.
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For some commodities and energy products the majority of trading takes place using
derivative contracts – only about 10% of trading is for spot transactions. So why are spot
prices important?
As you have seen already producers and users of commodities, such as rice, corn and crude
oil, are always seeking ways to lock in future income or costs so that they can plan their
businesses better.
Commodity prices are unpredictable and volatile. The prices are dependent on factors such
as weather conditions, crop disasters, political events, worker’s strikes etc. Buyers and
sellers of commodities constantly seek to protect themselves against these risks of price
volatility. If an oil producer can establish a price for crude oil today for future delivery, then
this helps the producer predict cash flows and manage future financial commitments.
Similarly, if a refinery can fix the price of future crude oil deliveries, then the prices of
energy products can be established in advance.
The derivative instruments used for transactions involving delivery of an asset or financial
instrument at a future date. These are:
 Forward contracts
 Futures contracts
Forward contracts:
Forward contracts exist for a variety of commodities and underlying assets including:
 Metals
 Energy products
 Interest rates – Forward Rate Agreements (FRAs)
 Currency exchange rates – Forward FX transactions
“A forward contract is a transaction in which the buyer and the seller agree upon the delivery
of a specified quality and quantity of asset at a specified future date. A price may be agreed on
in advance or at the time of delivery.”
Forward contracts are not traded on an exchange and do not have standardised,
transparent conditions. A forward contract involves a credit risk to both counterparties
as in the spot market. In such circumstances the counterparties may require some kind
of collateral that the other party will honour the contract.
Forward contracts are not normally negotiable and when the contract is made it has no
value. No payment is involved as the contract is simply an agreement to buy or sell at a
future date. Therefore the contract is neither an asset nor a liability.
A forward contract can be summarised as follows:

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Contract agreed today… ...for future date
Terms and conditions agreed: On settlement:
• Price • Delivery at agreed date, location, terms
• Quantity and quality and conditions
• Settlement date • Payment on delivery
• Location for delivery
• Any other conditions
But how are forward prices determined? In principle, the forward price for a contract is
determined by taking the spot or cash price at the time of the transaction and adding to
it a ‘cost of carry’.
Depending on the asset or commodity, the cost of carry takes into account payments
and receipts for matters such as storage, insurance, transport costs, interest payments,
dividend receipts etc.
Forward price = Spot or cash price + Cost of carry
Interesting examples of forward contracts are the benchmark contracts for base metals
on the London Metal Exchange (LME).
Although these are contracts traded on an exchange with some degree of transparency,
the contracts are for 3 months where market players can take positions for any business
day out to 3 months forward.
Why are the contracts 3 month forward? Three months historically was the time it took
for shipments of metals from South America to reach London. The LME is ultimately a
physical market whereby all contracts involve the actual delivery or receipt of ingots of
metal on the delivery date. The 3 month LME contracts are rolling contracts which
means that the contract expires exactly three months forward from the transaction
date. For example, a 3 month Copper contract bought on 12th June 2014 expires on
12th September 2014.
Forward prices are derived from the underlying cash prices as has been explained. If a
surplus of a commodity is expected in the future then forward prices will fall as the
expected spot price will decline. On the other hand if the commodity is predicted to be
in short supply in the future the forward price will increase.
In the energy markets there are informal forward markets in crude oils and oil products.
Forward markets have developed around marker or benchmark crude oils such as North
Sea Brent Blend (15- day Brent) and West Texas Intermediate (WTI). In many of these
forward contracts the parties agree to a cash settlement rather than take physical
delivery.
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The Brent 15-day market is the largest and most important crude oil forward market in
the world. The number of Brent forward contracts traded can exceed the actual volume
of crude oil produced many times over! The Brent forward contract gives 15 days’ notice
to the buyer to take delivery of a cargo at Sullom Voe during a notional 3- day loading
period.
A forward contract can be summarised as follows. Forward contracts are:
 Binding and non-negotiable

 Customised to customer requirements and are not reported
 Negotiable in terms of –
1. contract size
2. delivery grade of asset
3. delivery location
4. delivery date
The major advantage of a forward contract is that it fixes prices for a future date.
The major disadvantage of a forward contract is that if spot prices move one way or the
other at the settlement date, then there is no way out of the agreement for the
counterparties. Both sides are subject to the potential of gains or losses which are
binding.
Futures contracts:
The disadvantages and the problems posed for the early forward contracts traded to
arrive were resolved in the mid-1860s by the introduction of futures contracts. In 1865
CBOT laid the foundation to all modern futures contracts by introducing grain
agreements which standardised the following:
• The quality of the grain

• The quantity of grain for the contract
• The date and the location for the delivery of the grain
In effect the only condition left for the contract was the price. This was open to
negotiation by both sides but was carried out on the floor of the exchange using open
outcry. This meant that the prices settled were available to all traders on the floor – the
prices were transparent.
Over the next century or so more and more exchanges were established trading futures
contracts on a wide variety of commodities. By the early 1970s the world commodity
and financial markets had been subjected to dramatic political, economic and regulatory
changes leading to the introduction of floating exchange rates and vastly improved
communications systems and computers.
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All these factors combined to produce volatile markets in which producers/users of
commodities and issuers/buyers of financial instruments increasingly needed to protect
their assets from the risk of price fluctuations.
“A futures contract is a firm contractual agreement between a buyer and seller for a specified
asset on a fixed date in the future. The contract price will vary according to the market place
but it is fixed when the trade is made. The contract also has a standard specification so both
parties know exactly what is being traded.”
There are two basic types of asset for which futures contracts exist. These are:
• Commodity futures contracts

• Financial futures contracts
Although both contracts are similar in principle, the methods of quoting prices, delivery
and settlement terms vary according to the contract being traded.
Commodity futures comprise the following contracts based on:
• Softs – Cocoa, Coffee, Sugar, Orange juice

• Grains – Soybeans, corn, wheat, oats
• Livestock
Financial futures comprise the following contracts based on:
Interest rates – long-term interest rate futures are also known as Bond futures
• Currency exchange rates

• Equity stock indices
Both commodity and financial futures contracts are traded on exchanges worldwide.
Futures contracts share the following common features. They are:
• Standardised
• Traded on an exchange
• Open and their prices are published
• Organised by a Clearing house
The involvement of a Clearing house, which differs from exchange to exchange, means that
the contract is not directly between the buyer and the seller but between each of them and
the Clearing house. The Clearing house acts as counterparty to both sides which provides
protection to both sides and allows trading to take place more freely.
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It is important to remember that a futures contract does not predict what prices will be in
the future. It is also important to remember that if a contract is allowed to expire this means
that delivery must take place under the terms of the contract.
Trading on margin:
When a futures contract is agreed, the full contract price is not paid at that time. Instead,
both counterparties make an initial ‘good faith’ or margin payment to the Clearing house.
This initial margin or deposit is usually only 5-10% of the total contract value, different
exchanges and contracts require different initial margins. The fact that both counterparties
deposit initial margin assures the integrity of the contract.
Once a contract has been purchased, it can be sold and closed at any time prior to the
settlement date. With this in mind a futures contract is marked-to-market on a daily basis.
This means the contract value is calculated at the close of exchange trading every day it is
open.
All profits and losses are credited to or debited from the counterparties’ Clearing house
accounts daily. Any profits can be withdrawn but if the losses are such that the initial margin
is depleted, then extra margin, variation margin is required by the Clearing house. This
system of maintaining margin ensures the loser can bear any losses and that winners are
credited with their gains. A futures margin payment is in effect a performance pledge that
each of the counterparties’ obligations will be met.
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The system is illustrated in the following example for a futures contract for Silver.
Trading on margin is an example of gearing or leverage. Gearing allows market players to

make larger trades than could otherwise be afforded. Small margins can generate large
profits but equally large losses can also be made! Problems in the financial and commodity
markets may occur because sellers of futures have a limited amount of asset to protect
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whereas buyers may purchase a number of contracts on margin for short-term trading. For
example, for a buyer required paying a $1000 margin on a futures contract, this is equivalent to
buying $10-20,000 of commodity or financial asset if the contract expires.
The main difference is that a forward contract is a one-off OTC agreement between a buyer
and a seller, whereas a futures contract is a repeat offer traded on an exchange.
Who uses futures contracts?

The most important of the three groups of market players who are described as:
• Hedgers
• Speculators
• Arbitrageurs
Hedgers:
These are market players who wish to protect an existing asset position from future adverse
price movements. For example, both producers and consumers of commodities will hedge
their positions in the cash or physical markets using futures contracts. In order to hedge a
position, a market player needs to take an equal and opposite position in the futures market
to the one held in the cash market.
By using futures contracts, hedging removes the opportunity to profit if future cash prices
rise but provide the required protection if future cash prices fall. In this respect hedging is in
effect an insurance contract which locks in the future price of a commodity or financial
asset.
Speculators
Speculators accept the risk that hedgers wish to transfer. Speculators have no position to
protect and do not necessarily have the physical resources to make delivery of the
underlying asset nor do they necessarily need to take delivery of the underlying asset. They
take positions on their expectations of future price movements and in order to make a
profit. In general they:
• Buy futures contracts – go long – when they expect future cash prices to rise
• Sell futures contracts – go short – when they expect future cash prices to fall
Speculators provide liquidity to the markets and without them the price protection
/insurance required by hedgers would be very expensive.
Arbitrageurs
These are traders and market-makers who deal in buying and selling futures contracts
hoping to profit from price differentials between markets and/or exchanges.
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Relationship between cash and futures prices:
For most commodities the futures price is usually higher than the current spot price. This is
because there are costs associated with storage, freight and insurance etc which have to be
covered for the futures delivery. When the futures price is higher than the spot price the
situation is known as Contango.
If a chart is drawn of spot and futures prices then as the futures expiry date is approached
the plots converge. This is because the costs diminish over time and become zero at the
delivery date. The difference between the futures and spot prices at any time is called the
basis. A Contango chart for a 3 month futures contract might look something like this:
When the futures price is lower than the spot price the market is said to be in
backwardation. Backwardation occurs in times of shortage caused by strikes, under capacity
etc but the futures price stays steady as more supplies are expected in the future.
Contango markets indicate the future prices are at a premium to cash markets;
backwardation markets indicate a discount to cash prices.
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Basis patterns are very important to producers and are used in decisions such as:
• Accepting/rejecting cash offers for a commodity

• Whether and when to store crops
• When and in what delivery month to hedge
• When to close or lift a hedge
• When to turn an advantageous basis situation into a profit
Trading strategies
Hedging
There are two basic types of hedge that market players operate depending on their position.
In other words the hedge depends on their decision to buy or sell a futures contract. The
hedging strategies are:
• Short or seller’s hedge
• Long or buyer’s hedge
Spread trading
This type of trading is typically carried out by arbitrageurs and is concerned with price
differentials between cash and futures prices over time. It is not concerned with outright
futures prices or their price directions – up or down. Spread trading involves taking a long
position in one futures contract whilst simultaneously taking a short position in another.
Spread trading is only effective if there is a definite relationship between the contracts
being spread. For example, the same futures contract for different months.
There are two basic types of spread trading in common use:
• Time spreads
• Exchange spreads
Time spreads
These can be sub-divided into the following types:
• Intermonth spreads, for example, May – July, July – Sept etc.
• Basis intermonth spreads, for example, May – July, May – Sept etc.
• Basis spreads – the relationship between cash and futures prices
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In using spread trading, a dealer will purchase the cheaper or underpriced contract in his
view and sell the more expensive contract. In effect this is an arbitrage where the
simultaneous buying and selling of the same or similar instruments is used to profit from the
price differences.
If the markets move as expected the dealer profits from the change in the price relationship
between the contracts rather than the more volatile movements in absolute price. A profit
will always be made if the bought contract moves less than the contract sold.
Off-setting contracts
As the expiry date of a futures contract approaches, the contract price gradually tends to
the current cash price. In other words the basis or spread approaches zero. On expiry the
futures contract price equals the cash price.
For this reason, unless the buyer or seller wish to take or make delivery of the underlying
asset, the vast majority – over 95% – of futures contracts are closed out before the agreed
expiry date is reached.
Off-setting or closing out involves taking an equal and opposite position for exactly the
same contract.
The difference in price from the original contract transaction to that when the contract is
off-set represents the gain or loss on the trade. The process for a buy/sell close out is
illustrated below – for a sell/buy close out the positions are reversed.
Position For the same contract month Commodity or asset delivery
Initial Buy futures contract Agree to take
To off-set Sell futures contract Agree to make
Result Positions cancel = Close out Positions cancel = Close out
If the original contract price was $100.00 and the position was closed out at $102.00, then a
profit of $2.00 is made. If the position is closed out at $98.00, then the result is a loss of
$2.00.
Commodity and Energy futures contracts
Commodity futures contracts are some of the oldest traded derivatives. Commodity and
energy contracts’ details vary from type to type and from exchange to exchange. The
following example is taken from the specification for a CME contract and indicates the terms
and conditions involved with a typical commodities futures contract.
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Financial futures contracts
The worldwide economic and political upheavals of the early 1970s meant that many large
organisations and governments were exposed to rapid changes in interest rates and foreign
exchange rates. In order to hedge asset positions and protect against position exposures,
exchanges introduced a variety of currency and interest rate futures contracts. These
contracts were based on the principles established for commodity futures but were referred
to as financial futures in order to distinguish them.
Over the next decade a variety of financial futures contracts were introduced some are now
discontinued and no longer traded. The introduction of new contracts on exchanges is a
constant process as worldwide financial conditions change so does the need to hedge and
protect assets.
There are three broad types of financial futures as follows:

 Currency futures. These were first introduced by the International Monetary Market
division of the Chicago Mercantile Exchange in 1972.
 Interest rate futures. These were first introduced by the Chicago Board of Trade as
futures on Government National Mortgage Association (GNMA) certificates known
as Ginnie Maes in 1975. These contracts are no longer traded but many exchanges
now trade Interest rate futures on both short and long term assets. Contracts on
long term assets having bonds as the underlying instrument are also known as Bond
futures.
 Equity index futures. These were introduced by the International Options Market
division of the Chicago Mercantile Exchange as contracts on the Standard & Poor’s
500 Index in 1982. In the same year the Kansas Board of trade introduced a contract
on the Value Line Index.
Just as for commodity and energy contracts details for financial futures vary from type to
type and from exchange to exchange. The following example is taken from the specification
for a CME contract and indicates the terms and conditions for a EURO DOLLAR futures
contract.
Financial futures are used by market players to protect their assets against adverse price
movements. The positions they take depend on the market volatility and are summarised in
the table below.
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The importance of forwards and futures
In order to assess the importance of exchange traded futures contracts in the commodity
and financial markets worldwide it is necessary to compare them with derivatives traded in
the OTC markets. However, any comparison is not easy as it is almost impossible to compare
like-with-like. For example, futures contracts are not traded OTC.
It is possible to compare the derivatives of all types – forwards, futures, options and swaps
traded OTC and on exchanges. But what measures are used to compare statistics? Two
commonly used measures are as follows:
 Notional amounts outstanding. These are the notional values of trades concluded
but not yet settled. The measure provides an indication of market size and an
indication of potential transfer to price risk.
 Turnover. This provides a measure of market activity and of market liquidity. It is the
gross value of trades concluded but not yet settled in terms of the nominal value for
forwards, futures and swaps and in terms of notional amounts and premiums paid
and received for options. It is not possible to obtain market data from a single source
which covers all aspects of the derivatives markets. The data used for comparisons
here has been drawn from the following organisations:
 Bank for International Settlements (BIS)
 Commodities Futures Trading Commission (CFTC)
 The exchanges
OTC v Exchange traded derivatives

Although comparisons are difficult the BIS has produced a number of reports from which
the following.
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1. OTC trading dominates the derivative markets in terms of the notional amounts
outstanding. However, it must be noted that the Foreign exchange data here
includes those for Forward outright and FX Swap transactions. Some of the individual
derivative amounts are indicated.
2. 2. Based on average daily turnover amounts, OTC trading accounts for almost two-
thirds of worldwide derivatives trading.
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3. The most important OTC and Exchange traded derivatives contracts involve Foreign
exchange and Interest rates. In the OTC markets Foreign exchange derivatives
trading dominates accounting for over 60% of the market share. However, for
Exchange based trading, Interest rate derivatives account for almost 99% of the
market turnover.
What are options?
An option contract confers the right, but not the obligation, to buy (Call) or sell (Put) a
specific underlying instrument at a specific price (The strike or exercise price) up until or on
a specific future date(the expiry date).
The following chart is a summary of the rights and obligations of call and put holders and
writers.
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Option styles
Settlement of options is based on the expiry date. However, there are three basic styles of
options you will encounter which affect settlement. The styles have geographical names
which have nothing to do with the location where a contract is agreed! The styles are:
 American. These options give the holder the right, but not the obligation, to buy or
sell the underlying instrument on or before the expiry date. This means that the
option can be exercised early. Settlement is based on a particular strike price at
expiration.
 European. These options give the holder the right, but not the obligation, to buy or
sell the underlying instrument only on the expiry date. This means that the option
cannot be exercised early. Settlement is based on a particular strike price at
expiration.
 Asian. These are average price options. This means that settlement is based on the
difference between the strike price and the average price of the underlying
instrument for agreed conditions over the life of the option. Most Asian options are
exercised on the expiry date but it is possible to have an option which can be
exercised early – an American Asian option!
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It is worth noting the following concerning these different option Styles:
 Many Exchange traded options are American style, although not all. You will need to
check the contract specification to confirm the style being used. This is important as
some options on the same underlying instrument are available in American and
European styles, for example, PHLX Currency options on cash.
 Most OTC options are European style.
 American style options tend to be more expensive than European style because they
offer greater flexibility to the buyer.
The following chart summarises options in terms of buyers/holders and sellers/writers.
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Why do holders and writers use options?
In the same way that hedgers use futures instruments, so they use options as a risk
management tool as a form of insurance to remove or reduce the effects of adverse price
movements.
There are three types of option writers using the markets:
Market-makers These players manage the risks on their positions by selling and buying
options in the markets by quoting two-way prices. They provide liquidity to the markets and
profit from small bid/offer price differentials for the option contracts .
Producers These are naturally long in the underlying instrument. If they sell a call this means
the producer has the obligation to sell the underlying that he holds if the option is exercised.
If the market price for the underlying remains static or falls, then the holder will not exercise
the option at expiry. The producer thus profits from the premium received. However, if
prices rise and the option is exercised at expiry, then the producer loses on the option
because he has to sell the underlying at a lower price than the current higher price.
Consumers These are naturally short in the underlying instrument. If they sell a put this
means the consumer has the obligation to buy the underlying if the option is exercised. If
the market price for the underlying remains static or rises, then the holder will not exercise
the option and the consumer profits from the premium received. If the market price falls,
then the holder will exercise the option at expiry and the consumer will be obliged to buy
the underlying.
Speculators
These market players buy and sell options and take on the risk that hedgers wish to insure
against. Speculators use their market knowledge to predict future prices for instruments
and set up option trading strategies to profit from their views.
Arbitrageurs
These market players provide liquidity to the options markets by taking advantage of price
differences by simultaneously buying/selling similar options and/or underlying instruments
with a view to profit.
How options work
The fixed agreed price at which the underlying instrument may be bought (called in) or sold
(put out), on exercise of an option, is known as the strike or exercise price. Typically
exchange traded options have exchange determined strike prices above, below and near to
the current underlying instrument price.
The expiry date is the date and time after which an option may no longer be exercised.
Different option contracts have different contract months and depend to a large extent on
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the underlying instrument. For example, an option on a futures contract will have a last
trading day dependent on the underlying futures contract’s last trading day.
The premium is the price paid by the option buyer to the seller for a contract size which is
specified as a unit of trading. This unit of trading is again dependent on the underlying
instrument. For an option on a futures contract it is usually one futures contract of the
underlying; for equities it is typically 100 shares. You will need to look at individual contract
specifications for specific exchange traded options. All exchanges publish the contract
specifications for the options they trade. By their very nature OTC contract conditions are
much less transparent and more difficult to find published.
The premium may be considered to be the insurance cost to provide protection against
adverse price movements in the underlying instrument.
Strike prices
The most profitable time to exercise an option is taken from the relationship between the
strike price and the price of the underlying instrument.
The option which has a price at or close to the price of the underlying is known as At-The-
Money, ATM. For an option which has a strike price such that if the option were exercised
immediately a profit would be made, this option is known as In-The-Money, ITM. For the
situation where no profit would be made immediately, the option is known as Out-of-The-
Money, OTM.
The further away the strike price is from the ATM position, the deeper ITM or OTM the
option is said to be. Have a look at the following chart to see which Calls and Puts are ITM
and OTM depending on their strike price.
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Premium, Intrinsic Value and Time Value
The premium of an option has two components:
Premium = Intrinsic Value + Time Value
The Intrinsic Value, IV, of an option is the difference between the underlying and the strike
prices – the value must always be positive number or zero. The Intrinsic Value is a measure
of how much an option is In-The-Money.
Intrinsic Value = Difference between strike and underlying prices
Intrinsic Value = Underlying price – Strike price
This additional component is known as the Time Value and is the amount required to
compensate for the risk the writer has to take that the option will move ITM before the
option expires. For a Call option:
Time Value = Premium – Intrinsic Value
Swaps transactions
A swap transaction is the simultaneous buying and selling of the same underlying asset or
obligation of equivalent capital amount where the exchange of financial arrangements
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provides both parties to the transaction with more favourable conditions than they would
otherwise expect.
A swap is an OTC transaction between two parties in which the first party promises to make
a payment to the second party. In turn the second party usually promises to make a
simultaneous payment to the first party. The payments for both parties are calculated
according to different formulas but paid according to an agreed set of future scheduled
dates.
Interest Rate Swaps (IRSs)
An Interest Rate Swap is an agreement between counterparties in which each party agrees
to make a series of payments to the other on agreed future dates until maturity of the
agreement. Each party’s interest payments are calculated using different formulas by
applying the agreement terms to the notional principal amount of the swap.
 An IRS is an exchange or swap of interest rate payments calculated according to

different formulas on the same notional principal amount.
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 No exchange of principal occurs during the swap no funds are lent or borrowed
between the counterparties as part of the swap.
 Interest rate payments are usually netted and only the difference is paid to one party
or the other.
 Any underlying loan or deposit is not affected by the swap. The swap is a separate
transaction.
Currency swaps
A Currency swap is an agreement between counterparties in which one party makes

payments in one currency and the other party makes payments in a different currency on
agreed future dates until maturity of the agreement.
 A Currency swap usually involves an exchange of currencies between counterparties

at the outset of the agreement and at its maturity. If no exchange takes place at the
outset, then there must be an exchange at maturity. Because exchange of principal
takes place there is an additional credit risk attached to the transaction.
 Interest payments between the counterparties are usually paid in full.
 Interest payments on the two currencies can be calculated on a fixed or floating
basis for both currencies, or payments for one currency can be on a fixed basis and
floating for the other.
Commodity swaps
A Commodity swap is an agreement between counterparties in which at least one set of

payments involved is set by the price of the commodity or by the price of a commodity
index.
 A Commodity swap is usually a plain vanilla agreement which is purely financial

involving no delivery of the physical commodity.
 Market players on the floating price side usually buy and sell under contract terms
which are linked to a commodity index such as Platts for oil products. This means
that the actual delivery price is not known until, at or near delivery.
 Market players on the fixed price side accept the high degree of risk involved in
volatile commodity markets. They usually offset their risk by taking opposite
positions in the forwards or futures markets.
Equity swaps
An Equity swap is an agreement between counterparties in which at least one party agrees
to pay the other a rate of return based on a Stock Index, according to a schedule of future
dates for the maturity period of the agreement. The other party makes payments based on
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a fixed or floating rate, or another Stock Index. The payments are based on an agreed
percentage of an underlying notional principal amount.
 At least one payment is based on the rate of return of a Stock Index for an agreed
percentage of a notional principal amount.
 Equity swaps in effect transfer assets without involving the physical buying and
selling of equities or other financial instruments.
 Equity swaps provide an effective method of entering into overseas equity markets
without the restraints and complications of actually trading abroad.
Although these markets have been separated as Commodities, Energy and Transport they
are closely related. Commodities are the basic raw materials which provide people with the
food they need, the oil required for heating, power and gasoline, and the materials they
need for manufacturing goods. But without worldwide shipping and cargo markets these
commodities would not be transported from producer to consumer.
Fluctuations in the Commodities, Energy and Transport markets also impact on the Debt,
Equities, FX and Money Markets. For example, the cost of raw materials is a key to
forecasting inflation rates which impact on interest rates, which in turn affect the bond and
equity markets.
Supply, demand and the weather
Within the different markets, the market players all need as much information as possible in
order to buy and sell commodities, crude oil and energy products or charter vessels for
cargoes to their best advantage. The players are all seeking the most favourable prices or
contract conditions. But how are such prices or contract conditions determined?
Provided a market is operating freely the price of a commodity, product or service is a good
indicator of the demand for it. By allowing prices to move freely the markets match the
supply of the commodity, product or service to the demand. A marketplace acts therefore
as a pivot point in balancing supply and demand as shown in the diagram below.
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If supply exceeds demand, then prices fall and eventually production output or service
provision falls. The result is that demand exceeds supply. This effect causes prices to rise
which in turn causes production output or service provision to rise until a balance point is
achieved between supply and demand.
Prices of commodities, products and services can vary in both the short and long term based
on a wide variety of factors including the following:
 Weather
 Political/international events
 Availability and cost of labour
 Production/processing demands
Weather
This tends to be a major consideration for agricultural commodities. Adverse weather

conditions during the planting, growing and harvesting periods for a crop can have dramatic
effects on cash and futures prices for the commodity in the short term. Weather conditions
are also important in the long term for commodities involving long periods before being
sold, for example, crops involving plantations reaching maturity, livestock development etc.
A good example of the importance of weather is the phenomenon known as El Nino. The
phenomenon occurs every 3 - 5 years and originates in the South Pacific Ocean.
Political/international events
Events such as international wars and action taken by individual governments in an

international context can quickly impact on the markets. The prices of commodities and heir
availability can change dramatically within a very short period of time.
The availability of news on political events and their potential effects on the supply of
commodities, crude oil etc are therefore very important to market players.
Availability and cost of labour
Because of their very nature many crop commodities require large labour forces for
planting, growing and harvesting. For example, much of the worldwide coffee produced is
still harvested by hand and the availability and cost of labour is very important. The
transport of commodities is also important when considering the availability and cost of
labour. For example, a dock strike can severely affect the cash and future prices of
commodities.
Production/processing demands
Varying production/processing demands may influence prices, have a look at the following
two examples.
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Sugar and Wheat
The worldwide demand for these commodities is relatively stable on a monthly basis. In
other words consumers produce, for example, bread and products containing sugar on a
regular basis throughout the year. However, the supply of sugar and wheat is very much
dependent on the harvest yields of these commodities and on the stocks held by
governments and consumers. This means there is a situation of constant demand but of
variable supply.
Aluminium
The worldwide demand for this metal, on an annual basis, is somewhat variable. However,
the supply of the metal is relatively constant and stable. In general the warehouse stocks of
metals held by the London Metal Exchange are used as a global barometer of supply and
demand.
Commodities markets
What are they?

Commodity markets deal with the buying and selling of raw materials - commodities. These
markets are some of the oldest types and the concept of trading forward started here, that
is the buying and selling of a product for delivery at a future date.
There are two basic ways in which commodity trading can take place:
 The physical markets where traders buy and sell the actual commodity and settle the
deal in cash either spot or forwards – this is why these markets are sometimes
known as the cash markets. Typically trading takes place over the telephone and
occasionally in sale rooms or at auction. Trades are non-standardised and each deal
is individually negotiated for an individual commodity.
 The paper markets where Exchanges provide competitive markets for trading hard
and agricultural commodities futures contracts. These contracts have standardised
terms and conditions and the exchange acts as the counterparty between buyers
and sellers.
What are hard and agricultural commodities?

• Hard commodities are materials such as non-ferrous metals, including copper, lead,
tin, nickel, aluminium and zinc, and precious metals, including gold, silver, palladium
and platinum.
• Agricultural commodities include materials such as coffee, cocoa, sugar, grain, soya,
corn, rubber and cotton.
How do the physical markets work?
36
The terms and conditions of OTC spot and forward contracts are individually negotiated but
typically cover the following for the commodity being traded:
• Quality
• Quantity
• Delivery location
• Delivery terms, for example CIF or
• Settlement details
• Price
Settlement details
For spot transactions the settlement period is usually between 1 and 45 days depending on
the market conventions for a particular commodity. For some commodities the period is 2
days which is the same as used in the Foreign Exchange and Money Markets.
For forward transactions the settlement period is determined by the agreed date in the
future.
Types of commodities
The commodities are divided into two main types – hard and agriculturals. And are broadly
categorized in to three
The categories are:
• Metals which includes base, precious and strategic/minor
• Softs which includes coffee, cocoa, sugar, rubber, pepper, tea and citrus fruits
• Grains and Oilseeds which includes cereals, fibres, meal, livestock, soya and
oilseeds.
Metals
The metals markets are divided into the following three main areas:
Base metals
The original meaning of a base metal was one that dulls or tarnishes in contact with the air
at ordinary atmospheric temperatures. They contain no iron and include the major non-
ferrous metals of copper, aluminium, zinc, lead, tin and nickel. The chief market place for
these metals is the London Metal
Exchange (LME). Stocks delivered on LME contracts are held under warrant in LME
warehouses.
Strategic/minor metals
Strategic metals are produced as a by-product of base metal ore mining and include metals
such as antimony, bismuth, gallium, vanadium, silicon and selenium. Many of these metals
are used in the semi-conductor industry. Minor metals include many other metals such as
cobalt, cadmium and chromium and some minerals such as talc, barytes and fluorspar which
are used commercially. Strategic and minor metals are traded as physical markets mainly by
way of direct trade agreements between producer and consumer. For example, Sumitomo
of Japan market titanium direct to end-users in the automotive, aerospace and weapons
37
industries where it is used in the manufacture of certain types of steel alloys. Key consumers
of strategic and minor metals are the electrical, pharmaceutical, aerospace and automotive
industries.
Precious metals
These include the traditional coinage metals of silver and gold together with the rare metals
of platinum and palladium which are used in automotive catalysts for pollution control.
Most silver is obtained as a by-product of base metal mining and its price is affected by the
price of these metals. Although gold is no longer the international currency standard, its
price is still influenced by the equity and debt markets. Generally gold prices are more
influenced by political and economic factors rather than by levels of consumption.
Softs
In common with all commodity markets the prices of softs are subject to:
• Supply and demand fluctuations
• Adverse weather conditions
• Stock piles
• Harvest forecasts
• Transport costs
• Government programmes and subsidies
The most important soft commodities traded worldwide are:
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• Coffee
• Cocoa
• Sugar
There are smaller markets for rubber, orange juice, tea and pepper.
Grains and Oilseeds

The most important agricultural commodities traded worldwide:
Grains
These include wheat, barley, corn (maize in the US), rice and oats.
Oilseeds
This group includes the seeds that produce edible oils, oils for livestock feeds or oils
for industrial use. Seeds of importance worldwide are soybean, rapeseed, palm
kernel and flaxseed – the latter is used to produce linseed oil. This group also
includes meals and fertilizers.
Livestock
These markets are concerned with both live animals and meat products, for
example, frozen pork bellies. This group also includes dairy products such as milk and
cheese.
Fibres
These markets include wool, cotton and silk.
Most trading in these agricultural commodities takes place in the spot or cash markets and
it is sometimes difficult to obtain accurate prices as contracts are direct between producer
and consumer. The prices of these agriculturals are subject to the same factors as for softs
but in addition growth cycles have to be taken into account for example, a pig takes four
years to mature, cereals take time to grow etc.
Energy markets
Energy is an essential commodity for basic living requirements as well as providing the
power required for industrialised economies. Sources of energy used have to some extent
been dependent on their discovery and availability. For example, coal was a very important
source of energy in the nineteenth century. In 1886 the Coal Exchange was built in
Cardiff, Wales then the largest coal exporting city in the world. It was said that on the Coal
Exchange trading floor a millionaire was only an arm length’s distance away in any direction.
From the turn of the century oil became increasingly more important as the major world
source of energy. More recently Natural Gas has had a significant affect on energy supply
and usage. With the deregulation of power generation markets worldwide and
environmental pressures there is an interesting balance of energy sources and requirements
facing the markets.
39
Although oil is the most important energy market in terms of the value of worldwide trade
and as a source of energy, markets for other energy sources and generation are increasing
in importance.
The energy markets considered here are as follows:

• Oil
• Natural Gas
• Electricity
• Other
Petroleum and its products

The word petroleum is derived from the Latin for rock and oil – petra and oleum. Petroleum
is also frequently referred to as ‘oil’ – the terms are synonymous in many cases. Petroleum
is extracted from the earth’s crust as a brown to black liquid known as crude oil. It is normal
to find natural gas in association with crude oil – an important source of energy in its own
right.
Electricity markets
It is hard to imagine how many world economies would survive without electricity. Its
availability is essential for both domestic and industrial use.
In many countries electricity has been supplied traditionally by large suppliers, often
nationalised or public industries, at regulated prices on a regional basis. In other words, if
you lived in a particular power generating utility region that was the company who supplied
your electricity. Since the early 1980s there have been a number of major changes taking
place to affect the electricity supply industries in many countries. Wholesale power markets
have been established and developed depending on the following factors, in part at least:
40
• Deregulation. It is now the cases that in many countries in Europe and regions in the
US that domestic and industrial customers can now choose their electricity supplier.
Access to national transmission grid systems is now possible for a variety of power
generating organisations and more importantly to power marketers – buyers and
sellers of wholesale electricity as a commodity.
• Price competition. The price of this commodity depends on the fuel or energy
source used for generation. For example, power can be generated not only using
Natural
Gas, coal, oil, nuclear sources but also from renewable sources such as hydroelectric
schemes, solar panels, wind generators and geothermal sources. The price is also
subject to seasonal supply demands.
• Technological advances. Improvements in power generation and distribution.
The combination of all these factors means that there is now a significant market risk
associated with the generation of electricity. As in other commodity markets the producers
and consumers may need to hedge their relative positions whilst power marketers buy and
sell for profit.
Electricity is known as a flow commodity because it cannot be stored in the conventional

sense. Commodities such as crude oil are known as cash and carry because once bought
they can be stored.
Active cash or spot markets together with derivative markets have been established and
developed in a number of countries. It is now possible to buy and sell wholesale power in
advance for later delivery and hedge or speculate on positions using futures and options on
futures contracts just as for other commodities.
Overview of the functioning of wholesale power markets
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Base:
Base load comprises a constant delivery rate on all delivery days from Monday to Sunday
and during all 24 delivery hours of a delivery day during the delivery period.
Peak:
The highest electric requirement occurring in a given period (e.g., an hour, a day, month,
Season or year). For an electric system, it is equal to the sum of the metered net outputs of
all generators within a system and the metered line flows into the system, less the metered
line flows out of the system.
Peak load comprises a constant delivery rate on all delivery days from Monday to Friday or
Monday to Saturday depending on the region and during all peak delivery hours of a
delivery day during the delivery period.
Off Peak
Off-peak is the difference between base load and peak load. This load profile comprises the
delivery days from Monday to Friday during hours apart from peak hours as well as the time
from 00:00 AM to 12:00 PM from Saturday to Sunday.
Electricity providers would prefer to provide a steady supply of electricity throughout the
day and night, because the turbines that generate electricity cannot be easily turned on and
off as we need power in our homes. People generally use most of their electricity during the
morning and evening. To encourage people to use electricity during other times of the day,
many providers offer cheaper electricity during periods known as off peak electricity times.
In homes, off peak electricity is commonly used to heat water and can also be used to
power other heating appliances that are able to store heat when not in use.
In the spot markets electricity is bought in units of Mega Watt hours (MWh). In a single day
the price can vary considerably with the time of use as illustrated here:
Another important cash market is the forward market which is known as the day-ahead or
next-day market. For these forward electricity contracts power generators analyse
predicted usage, watch the weather and make decisions about meeting consumer’s power
requirements for the next day. Typically forward transactions involve blocks of 50 MWh of
power.
Day-ahead market:
Exchanges usually provide a day-ahead market (also called spot market), where the bids are
submitted and the market is cleared on the day before actual delivery. Every day open for
trading is divided into periods (e.g. 24 blocks of 1 hour each). Each bidder makes a price bid
for every generation unit for the whole day. On the whole, hourly contracts (for the 24
hours of the calendar day) or block contracts (i.e. a number of successive hours) are traded
in the day-ahead market. Whereas hourly trading allows the market participants to balance
their portfolio of physical contracts, block trading allows them to bring complete power
plant capacities into the auction process.
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Real-Time Energy Market
Real-Time Market is a spot market in which current locational marginal pricings are
calculated at five-minute intervals based on actual grid operating conditions. The real-time
prices are posted and Transactions are settled hourly; invoices are issued to market
participants monthly.
Intra-day market:
Due to the long time span between the settling of contracts on the day-ahead market and
physical delivery, exchanges sometimes offer an intra-day market. Intraday trading allows
for purchase and sale of a product within a given trading day. This market closes a few hours
before delivery and enables the participants to improve their balance of physical contracts
in the short term.
Season contracts
These are of six individual and consecutive contract months. Season contracts are always an
(April - September) strip or (October – March) strip.
Quarter contracts
These are of three individual and consecutive contract months. Quarter contracts always
comprise a strip of (Jan - Feb - Mar) or (Apr - May - Jun) or (Jul - Aug - Sep) or (Oct - Nov -
Dec).
Quarterly Peak Load Futures Contracts
1 Megawatt of electrical energy per hour based on a peak load profile. Where the peak load
profile is defined as the Wholesale Electricity Pool Market peak load period from 07:00am
hours to 10:00pm hours Monday to Friday (excluding Public holidays and any other days
determined by ASX) over the duration of the Contract Quarter.
The size (in Megawatt hours) of each contract quarter will vary depending on the number of
peak days and peak load hours within the quarter, as follows:
• A 59 day contract quarter will equate to 885 Megawatt hours;
• A 66 day contract quarter will equate to 990 Megawatt hours.
Tick size for a $0.01/MWh price fluctuation:

• A 885 MWh contract quarter has a tick size of $8.85;
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• A 990 MWh contract quarter has a tick size of $9.90.
Month contracts
These are made up of individual and consecutive calendar days. A monthly contract is 28,
29, 30 or 31 individual day contracts, determined by the precise number of calendar days in
the month.
A generating company is planning to sell all the power generated by its plant in the month
of September 2014 (24 hours, 30 days) on the Spot Market via hourly contracts. It expects
an average price of $ 53.50 per MWh. Since the Spot Market price cannot be forecast with
certainty, it decides to conclude a price hedging transaction on 1 July 2014 by selling 30
contracts of the Base Month Future for September 2014 at $ 53.50 per MWh. The planned
revenue from the delivery of power amounts to “30 MW x 24 h/day x 30 days x $ 53.50 per
MWh = $ 1,155,600“.
The generating company sells approx. 30 MW per hour beginning on 31 August 2014 for the
first delivery day (1 September 2014) and ending on 29 September 2014 for the last delivery
day (30 September 2010) as planned. This means it submits price-independent bids for each
one of the delivery days in September with the result that it sells the 30 MW in every hour
at the respectively applicable Spot Market price. As a result, it achieves a price exactly
corresponding to the average value of the daily Spot Market index, however, in this example
the average has fallen to below the planned value of $ 53.50 per MWh. The generating
company only earns $ 47.53 per MWh on average on the Spot Market and, this result falls
short of the expected revenue by $ 128,952. However, the profits (Variation Margin) from
the futures contract totalling $ 128,952 offset exactly this shortfall in revenue of EUR
128,952. This clearly shows that the planned revenue totalling $ 1,155,600 was fixed upon
the conclusion of the futures transaction. It consists of the revenues on the Spot Market
totalling “21,600 MWh x $ 47.53 per MWh = $ 1,026,648“and of the revenues on the
Derivatives Market totalling “21,600 MWh x ($ 53.50 per MWh – $47.53 per MWh) =
$128,952“.
It is important to recognise that in this forward market every next-day contract is unique.
It is worth noting that different exchanges use different contract sizes. For example, ICE
contracts are for 392 Mega Watt Hours (Mwh) of power delivered over a monthly period,
and the SFE contracts are for 672 Mwh.
The risks for market players in the electricity markets have predictably lead to the
introduction of OTC and exchange traded derivative contracts. Producers and consumers of
this commodity need to hedge their risks and speculators provide liquidity in the markets.
44
There are now several exchanges worldwide trading electricity futures and options on
futures contracts. These contracts specify a particular geographical delivery point for an
amount of power to be delivered daily during the on-peak hours for a contract month.
Electricity futures and options on futures contracts are now traded on a number of
exchanges worldwide, including the following:
• New York Mercantile Exchange (NYMEX)
• ASX (SFE)
• Scandinavian NordPool
• Finnish Electricity Exchange
• Inter-Continental Exchange (ICE)
• European Energy Exchange (EEX)
EEX Derivatives Market:

• Phelix Base Week Futures
• Phelix Peak Week Futures
• Phelix Base Year/Quarter/Month Futures
• Phelix Peak Year/Quarter/Month Futures
• Phelix Off-Peak Year/Quarter/Month Futures
• French Baseload Futures
• French Peakload Futures
• French Base Week Futures
• French Peak Week Futures
Calculation of Power Lots for Peak and Off Peak (ICE exchange)
POWER LOTS BY
MONTH.xlsx
Monthly Base Load Futures Contracts
1 Megawatt of electrical energy per hour based on a base load profile, Where the base load
profile is defined as the Wholesale Electricity Pool Market base load period from 00:00
hours Monday to 24:00 hours Sunday over the duration of the Contract Month.
For example: the size (in Megawatt hours) of each contract month will vary depending on
the number of days and base load hours within the month, as follows:
• A 28 day contract month will equate to 672 Megawatt hours; (28DAYS*24 HOURS)
• A 31 day contract month will equate to 744 Megawatt hours. (31DAYS*24 HOURS)
Tick size for a $0.01/MWh price fluctuation:

• A 672 MWh contract month has a tick size of $6.72;
45
• A 744 MWh contract month has a tick size of $7.44:
Other exchange traded electricity futures contracts have different delivery amounts but are
calculated in a similar way.
Balance of the Month (BOM/BALMO)
Balmo is a market abbreviation for ‘Balance-of-Month’ and is used in the Commodity products.
These contracts comprise a string of individual day contracts with the precise number
determined by the number of days still outstanding in the current month. The BOM contract
therefore reduces in size on a daily basis, generating a daily contract representing the
delivery obligation of that day.
If the market of daily futures existed, the hedging of daily options would not be different
from that of monthly options and the approach described above would be applicable.
However, most markets – except perhaps for the Nordpool - do not have liquid daily
forward or futures contracts, and therefore, we are forced to use an imperfect and
sometimes dangerous surrogate of this daily futures contract in the form of the balance of
the month contract. The balance of the month price is the price of power/Natural
Gas/Crude Oil delivered every day from today until the end of the current month.
Balmo’s are usually go along with Swap Futures fixed with floating Price. Example
Crude Outright – Brent 1st Line Swap Future

Crude Outright – Brent 1st Line Balmo Swap Future
With floating price Balmo’s are usually settled or fixed. Fixed-for-floating Energy products
have been increasingly more important in the derivatives markets. Producers and
consumers of commodities are often linked to long term contracts to buy or sell where the
delivery price is determined by an index price. This means that the price at delivery is not
known until a short time beforehand or until the actual delivery date. Under these
conditions there is a considerable floating price risk.
Many organisations have a floating price risk as they buy and sell under contract terms
which are linked to an index such as Platt’s prices for energy products. This means that the
actual price is not known until at or near delivery.
Crude Oil Swaps are generally available as a basis against cargo size parcels and although in
the financial crude oil markets you may be able to execute 25,000 to 50,000 barrels
minimum, in the physical market cargoes typically range in size between 500,000 barrels up
to a VLCC at 2 million barrels. In each case, the financial swap is entirely aligned with a
46
physical spot assessment appearing within the Platts European Marketscan publication or
physical deals of the Exchange.
Besides the average of the month contracts, in order to meet the needs of the industry
there also exists an active market for Balance of the Month or ’Balmo’ swaps, primarily
around hedging specific physical requirements. These are priced for the remaining days of a
calendar month, not the full calendar month like a fixed price Contract.
For example, if a Balmo Contract is executed on the 4th day of the month, then the Contract
will be priced from the 4th day of the month to the last business day of the Contract month.
Balmo Contracts allow Crude oil market participants greater flexibility in customizing the
time period used to hedge an exposure. These are less liquid, but the price implication from
one to the other is generally strong.
Balance Month or ’Balmo’ swaps, which take an assessor’s price from the day of trade to the
end of that calendar month, rather than an entire calendar month allow the very precise
hedging of physical prices, and thus allow perfect hedges to be constructed where the
physical price exposed to is exactly matched by the tenor of the swap and the related
physical index.
BALMO closer to end of the month, the less liquidity we find on such contracts. The
Intercontinental Exchange, CME Group and European Energy Exchange are some of the
Exchanges where Balmo’s are traded.
Weather Markets
The importance of weather concerning commodities is well known. Most commodity and
energy instruments have a trading unit of an underlying physical commodity such as crude
oil, coffee, sugar, corn, cattle etc.
In the early 1990s the Chicago Board of Trade (CBOT) introduced futures and options
contracts on Catastrophe Insurance with trading units based on US national or regional loss
indices provided by the Property Claim Services (PCS). More recently CBOT have introduced
US Corn Yield Insurance futures and options contracts for national and certain state yield
estimates. The underlying instrument for these contracts is the estimate for corn published
by the US Department of Agriculture (USDA), during the growing/harvest season.
However, more recently Weather derivatives have been introduced into the OTC markets
where the underlying instrument is a weather index or variable. In particular option
contracts are available for specific locations and calendar periods based on Heating Degree
Days (HDD), or Cooling Degree Days (CDD).
These weather options provide hedging instruments for market players such as energy
producers and consumers who have weather related risks. For example, an energy producer
in the US may be expecting a hot summer requiring a high cooling demand for air
conditioning etc. If the temperatures fall, then cooling demand falls resulting in a loss of
47
revenue for the energy producer. The producer would like to protect this risk and these
recently introduced weather options provide a hedging strategy.
Options such as floors and caps are written using a strike which is based on a temperature
index such as HDD or CDD. Once written and bought weather options are used and
exercised like any other type of OTC option.
In early 1999 the Chicago Mercantile Exchange (CME) announced its intention to offer
exchange traded futures and options on futures contracts for temperature related weather
derivatives. These HDD and CDD futures contracts will use indexes for a number of US cities,
including Atlanta, Chicago, Cincinnati, Dallas, New York and Philadelphia. The HDD and CDD
futures contracts will have a trading size of $100 times the CME HDD index and $100 times
the CME CDD Index – the index values are based on cumulative monthly HDDs and CDDs.
For the CME Index futures contracts:

 A Heating Degree Day occurs when the average temperature is below 65° Fahrenheit
 A Cooling Degree Day occurs when the average temperature is above 65° Fahrenheit
Until recently, insurance has been the main tool used by companies' for protection against
unexpected weather conditions. But insurance provides protection only against catastrophic
damage. Insurance does nothing to protect against the reduced demand that businesses
experience as a result of weather that is warmer or colder than expected.
In the late 1990s, people began to realize that if they quantified and indexed weather in
terms of monthly or seasonal average temperatures, and attached a dollar amount to each
index value, they could in a sense "package" and trade weather. In fact, this sort of trading
would be comparable to trading the varying values of stock indices, currencies, interest
rates and agricultural commodities. The concept of weather as a tradable commodity,
therefore, began to take shape.
In 1997 the first over-the-counter (OTC) weather derivative trade took place, and the field of
weather risk management was born. According to Valerie Cooper, former executive director
of the Weather Risk Management Association, an $8 billion weather-derivatives industry
developed within a few years of its inception.
In Contrast to Weather Insurance
In general, weather derivatives cover low-risk, high-probability events. Weather insurance,

on the other hand, typically covers high-risk, low-probability events, as defined in a highly
tailored, or customized, policy. For example, a company might use a weather derivative to
hedge against a winter that forecasters think will be 5° F warmer than the historical average
(a low-risk, high-probability event). In this case, the company knows its revenues would be
affected by that kind of weather. But the same company would most likely purchase an
insurance policy for protection against damages caused by a flood or hurricane (high-risk,
low-probability events).
48
Weather Futures and Options on Futures
In 1999, the Chicago Mercantile Exchange (CME) took weather derivatives a step further and
introduced exchange-traded weather futures and options on futures - the first products of
their kind. OTC weather derivatives are privately negotiated, individualized agreements
made between two parties. But CME weather futures and options on futures are
standardized contracts traded publicly on the open market in an electronic auction-like
environment, with continuous negotiation of prices and complete price transparency.
Broadly speaking, CME weather futures and options on futures are exchange-traded
derivatives that - by means of specific indexes - reflect monthly and seasonal average
temperatures of 15 U.S. and five European cities. These derivatives are legally binding
agreements made between two parties, and settled in cash. Each contract is based on the
final monthly or seasonal index value that is determined by Earth Satellite (EarthSat) Corp,
an international firm that specializes in geographic information technologies. Other
European weather firms determine values for the European contracts. EarthSat works with
temperature data provided by the National Climate Data Center (NCDC), and the data it
provides is used widely throughout the over-the-counter weather derivatives industry as
well as by CME.
Measuring Daily Index Values
An HDD value equals the number of degrees the day's average temperature is lower than
65° F. For example, a day's average temperature of 40° F would give you an HDD value of 25
(65 - 40). If the temperature exceeded 65° F, the value of the HDD would be zero. This is
because in theory there typically would be no need for heating on a day warmer than 65°.
A CDD value equals the number of degrees an average daily temperature exceeds 65° F. For
example, a day's average temperature of 80° F would give you a daily CDD value of 15 (80 -
65). If the temperature were lower than 65° F, the value of the CDD would be zero. Again,
remember that in theory there typically would be no need for air conditioning if the
temperature were less than 65°F.
For European cities, CME's weather futures for the HDD months are calculated according to
how much the day's average temperature is lower than 18° Celsius. However CME weather
futures for the summer months in European cities are based not on the CDD index but on an
index of accumulated temperatures, the Cumulative Average Temperature (CAT).
HDD and CDD are calculated as follows:
Daily HDD = Max (0, base temperature – daily average temperature)
Example: Calculate the HDD for one day when the average outside temperature is 13ºF.
Heating Degree Day = 65ºF - 13ºF = 52ºF
49
Calculate the HDD for one day when the average outside temperature is 2ºC.
Convert from Celsius to Fahrenheit: 2ºC = 35.6ºF
Heating Degree Day = 65ºF - 35.6ºF = 29.4ºF
Day Average Temperature Base Temperature HDD
Sunday 49° F 65° F 16° F

Monday 47° F 65° F 18° F
Tuesday 51° F 65° F 14° F
Wednesday 60° F 65° F 0° F
Thursday 65° F 65° F 0° F
Friday 67° F 65° F 0° F
Saturday 58° F 65° F 7° F
Average Temperature for the Week 60° F
Daily CDD = Max (0, base temperature – base temperature)
Day Average Temperature Base Temperature CDD
Sunday 76° F 65° F 11° F

Monday 66° F 65° F 1° F
Tuesday 64° F 65° F 0° F
Wednesday 60° F 65° F 0° F
Thursday 68° F 65° F 3° F

Friday 70° F 65° F 5° F
Saturday 74° F 65° F 9° F
Average Temperature for the Week 29° F
Measuring Monthly Index Values

A monthly HDD or CDD index value is simply the sum of all daily HDD or CDD value recorded
that month. And seasonal HDD and CDD values, accordingly, are simply accumulated values
for the winter or summer months. For example, if there were 10 HDD daily values recorded
in Nov 2004 in Chicago, the Nov 2004 HDD index would be the sum of the 10 daily values.
Thus, if the HDD values for the month were 25, 15, 20, 25, 18, 22, 20, 19, 21 and 23 the
monthly HDD index value would be 208.
The value of a CME weather futures contract is determined by multiplying the monthly HDD
or CDD value by $20. In the example above, the CME November weather contract would
settle at $4,160 ($20 x 208 = $4,160).
50
Temperature Contracts
A degree day is the deviation of a day’s average temperature from 65 degrees Fahrenheit.
In the summertime, the demand for energy increases with every degree above 65; in the
winter, the demand for heat increases for every degree day below 65. There are a number
of degree-day products available to energy producers. In most, payment is made for every
degree day above or below the strike, with a maximum pay out that can range from
$500,000 to $5 million or more.
Degree-day swaps
An energy producer that sells a swap is compensated for a certain amount per degree day
whenever degree days settle below or above an agreed strike level.
Degree-day options
An energy producer buys a put and is paid a fixed amount per degree day whenever the
degree days settle below an agreed strike.
Degree-day collars
Producers buy a put on a low strike and sell a call on a high strike to lock in a certain range
of degree days. In the cost-free collar variety, the premiums of the call and put cancel each
other out, resulting in no cost to the producer.
Degree-day straddles
Producers hedging against a massive shift in demand can enter into a straddle, which allows
for protection against extreme moves irrespective of the direction of the move.
Digital options
Producers hedging against massive demand spikes can also use digital structures, in which a
single lump-sum payment is stipulated when the temperature hits a certain strike.
Other Weather Derivatives
Dual-trigger options
A company can hedge against multiple weather events with dual-trigger options. For
instance, a farmer adversely affected by an 85-degree average temperature with 0.5 inches
of rainfall can enter into a dual-trigger option to protect against both using a single
structure.
Compound options: Companies wary of locking into an option can use a compound option,
in which they pay only a fraction of the option premium up front, and later—usually after
evaluating updated long-range forecasts—have the option of entering fully into the
structure.
Guaranteed forecast: Aquila, the weather derivatives trading subsidiary of Utilicorp, offers
option products based on the National Weather Service’s four- to eight-day forecast. If the
actual temperatures fall above or below the forecast, holders receive payments.
Precipitation and wind speed contracts: Companies can enter into options, swaps and other
structures based on precipitation or wind speed indices provided by the National Weather
Service.
51
Snow Futures
The amount (inches) of snow that falls in a specific area can be traded as a futures contract or
option. Contracts can be traded for snow at various geographical locations, usually designated by a
major airport in a city. Rain/snow futures are traded on the Chicago Mercantile Exchange.
Snowfall futures can be used by utility companies, transportation services, mail operations,
farmers, etc to hedge their risk against excess snow or rain. It can also be used by
companies that provide services such as sprinkling salt on roads to hedge risk against light
snow.
The snowfall product suite includes six different contracts in 10 locations. The CME Snowfall
Index provides average monthly snowfall information for designated cities in the United
States. People who wish to trade snowfall futures or options determine what amount of
snowfall would be detrimental to their businesses and take futures or options positions
based on that determination.
Hurricane futures
Weather futures specifically tied to Atlantic hurricanes are trading on the Chicago Mercantile
Exchange. The National Weather Center’s hurricane forecasters predict 13 to 17 named storms
every year, three to five of them potentially major hurricanes, defined as Category 3 and above on
the scale used to measure the storms.
Hurricane futures will allow energy traders to hedge risks in their positions and allow
speculators to bet on the potential impact Atlantic storms will have. Eventually, reinsurers
might be attracted to them as another way to offset risks in their portfolios.
The CME contracts are based on an index developed by Carvill, a firm that traces and
calculates hurricane activity. It takes the standard Saffir-Simpson Scale of hurricane strength
and beefs it up, adding the geographic size, or radius, of the storm to its wind velocity and
other factors.
Say an Atlantic tropical storm forms, strong enough to be named, and appears headed for
landfall. The corresponding CME hurricane futures contract will begin trading, at $1,000 per
point on the Carvill index. (CME will have three contracts lined up at any one time, with
numbers corresponding to the named storms.)
Suppose the storm starts out at medium strength and many think it’s going to strengthen
before it makes landfall. A trader who pays $2,000 for a futures contract on a size 2 storm
stands to profit $2,000 if the storm makes landfall as a size 4 storm on the scale, or lose the
cost of the contract if the storm peters out.
In the same vein, a trader who doubts the storm will keep its strength could sell (or short)
the futures contract on a size 2 storm and profit $1,000 if it makes landfall as a size 1 storm.
In a real-life scenario, an energy trader who is long in his natural gas positions but thinks the
storm won’t be as bad as predicted at landfall could short hurricane futures to hedge his
52
natural gas position. The gains from shorting the hurricane futures would offset the losses
from his natural gas positions.
Other energy markets
The importance of coal as an energy source in the nineteenth century has already been
mentioned. More recently, as a result of deregulation in worldwide power generation and
economic factors, OTC derivative contracts are being traded – the first coal swaps were
arranged by the broker TFS in 1998.
Transport markets
There are two transport markets which will be considered briefly here. These are:
 Shipping bulk markets
 Air cargo markets
Shipping bulk markets
Why are there markets?

Ships have been used for the bulk transport of commodities around the world from ancient
times. Today there are four basic reasons why shipping markets exist:
 The supply and demand for commodities
 Most commodities are not produced where there are needed and therefore need to
be transported
 There are differentials between commodity prices which provide an opportunity for
arbitrage
 Economic factors affecting governments, producers and consumers.
The majority of commodities shipped today involve wet cargoes using tankers and dry
cargoes using bulk carriers. Four commodities: crude oil, coal, iron ore and grain account for
about two-thirds of all seaborne trade. The remainder being a variety of agricultural
products, minor ores, timber, rubber, fibres, chemicals, heavy plant and machinery, cars,
steel and consumer goods.
There are usually three parties associated with the shipping market who are described in
greater detail later. In brief the ship owner and the charterer (the cargo owner) are brought
together by a shipbroker who acts as an intermediary to negotiate the fixture of a vessel
with a cargo.
Dry bulk cargoes – The Baltic Exchange
53
This exchange is the only international shipping exchange in the world. Although the Baltic
Exchange still maintains a floor for members to meet and trade, most fixing of ships is
carried out between members from their offices. The exchange’s main role is concerned
now with the proper regulation of the market and member transactions. The Baltic
Exchange motto Our Word Our Bond is still appropriate today.
The Baltic Exchange is primarily concerned with fixing worldwide dry bulk cargoes such as
coal, iron ore, grain, steel, minerals etc. The Baltic Freight Index (BFI) is produced from a
basket of 11 major, international dry cargo routes by Baltic brokers on a daily basis. This
index is a measure of the cost of the international ocean transport of major dry bulk
commodities.
The Baltic Exchange Freight Futures Exchange (BIFFEX) was established in 1985 to provide
exchange traded instruments for ship owners and charterers to hedge their risks in the dry
cargo market. BIFFEX freight futures are traded on LIFFE and as with other index contracts
they are cash settled.
Air cargo markets

Why are there markets?
Although shipping dominates the transport markets in terms of tonnage and international
trade value, there is still a need to transport certain goods and materials quickly around the
world. The air cargo markets serve these needs where airlines and charter companies
provide the cargo space for forwarders and shippers.
Delivery/settlement methods
Spot, cash and physical settlement and delivery
Spot transactions:
A Spot contract is a privately negotiated OTC transaction which takes place between a buyer
and a seller. Prompt delivery is usually between 1 and 45 business days after the trade date.
A Cash contract is settled in cash using one of the following as the basis for the settlement:
 A physical price index – for example, Platt’s Crude Oil price
 An official price – for example, an ICO Coffee price
 A price fixed by an exchange – for example, the LME Base Metal Cash Settlement
prices. On the LME Prompt delivery is usually for 2 business days after the contract
expiry date.
A Physical delivery contract means that the buyer of the contract will take actual delivery of
the commodity.
Spot transactions are those carried out ‘on the spot’. They are OTC transactions widely used
in the commodities and energy markets, although in some cases the deals take place in an
auction or sales room. The details of a spot transaction such as amount, price, delivery
location and date are agreed privately by both sides to the trade. Once the deal has been
54
made, depending on the market conventions, the spot settlement date could be between 1
day up to a month or so. On the settlement date the seller receives payment and the buyer
takes ownership of the commodity.
For example, the OTC spot market for gold is very similar to that for FX markets – prompt
delivery two business days after the trade date.
In the oil markets, spot transactions for Dated Brent, for example, refer to a specific, date
identified cargo.
Spot transactions and official prices are important both in the physical markets and for
pricing forward and futures contracts. Forward and exchange traded futures contracts
either use physical or cash settlement for delivery as the underlying instrument on contract
expiry.
Physical settlement
This describes a market where the contractual agreement is for the buyer to physically take
delivery of a commodity.
Cash settlement
This type of transaction infers that the contract is settled in cash.

Exchange traded futures commodities and energy contracts provide examples of physical
and cash settlement if the contracts are not closed out and allowed to expire. In most cases
if the contract is allowed to expire, then one of two conditions usually applies:
 The buyer of the contract takes physical delivery of the commodity. For example the
buyer will take delivery of 25 tonnes of copper which has been stored in a
warehouse, 500,000 barrels of oil from a VLCC or 736 Mwh of electricity delivered
over the next month.
 The buyer of the contract settles in cash using a physical price index which is agreed
the settlement being calculated on the difference between the contract price index
value and that at expiry. The index may be calculated and published by the exchange
as for Crude oil contracts on the IPE or an index produced by an independent
organisation such as Platt’s may be used.
Most exchanges publish Official Settlement bid and offer prices which are used for daily
margin payments and contract settlement on expiry. These settlement prices are for cash
but are also used by market players in the spot markets to price contracts. However, in most
cases they are used as a price guide only. On the LME both bid and offer Official Cash and
Forward prices are published and it is not uncommon for spot transactions to use these
prices for the contract conditions.
As with all OTC markets there are disadvantages in the spot commodity and energy markets
which include the following:
 The lack of contract transparency. Although Official or Index prices are published,
these only act as guides for the spot markets.
55
 The cost and time involved in setting up a trade. In many cases brokers are used who
match buyer and seller requirements.
 Creditworthiness of counterparty. Both sides of a trade have to be convinced that
payment/delivery will take place on the due date.
 Possibility of default in a volatile market place.
 Price risk associated with a volatile market.
In store/Ex store
This is the simplest form of physical delivery and is often used for base metals, cocoa and
coffee. The seller is responsible for delivery of the commodity to an agreed warehouse. As
with all physical deals the quality, quantity, delivery location etc., of the commodity are
negotiated on a contract by contract basis. Where the contract is linked to a futures
contract the commodity is delivered to an exchange approved warehouse and the
commodity must be ‘on warrant’ before it can be traded. The commodity must fulfil the
exchange quantity and quality contract specifications. These specifications have to be
fulfilled by the seller prior to the buyer paying for the commodity. The following table
indicates the types of issues involved with the quantity and quality of commodities.
If everything is in order the warehouse issues a warrant identifying the lot. This warrant is a
bearer document and is therefore valuable. When the lot is traded, the original warrant
owner is cancelled and ownership of the commodity transfers to the buyer together with
the warrant. The lot can now be shipped for delivery if required or placed back on warrant
in the warehouse – the new buyer is now responsible for storage costs. If the new owner
does place the lot on warrant, then delivery has taken place without the commodity even
moving!
The difference between ‘on warrant’ and ‘on cancelled warrant’ stocks held in a warehouse
can be used to assess the amount of true market trading.
Ex store
This is identical to In store except that the seller has to pre-pay the storekeeper for loading
onto the buyer’s transport. This is used for cocoa and grain delivered in the UK. Grain
samples are drawn on delivery to the buyer’s transport for analysis and grading by an
independent analyst.
In all physical deliveries the seller delivers the required documents, that is, grading
certificates, warrants, weight notes etc., to the nominated party for the transaction, for
example, Bank or exchange clearing house. Once delivered, payment is arranged and the
documents are exchanged for cash from the buyer.
Free On Board (FOB)
FOB is concerned with the loading and shipping of bulk commodities, such as gasoil, raw and
white sugar, soybean meal and potatoes that can be poured into a vessel. In essence FOB
means that once the goods have passed over a ship’s rail at the named port of shipment,
the seller has fulfilled their obligations. The buyer then bears all costs and risks for loss or
damage to the goods. FOB also requires that the seller clears the goods for export.
56
Cost-Insurance-Freight (CIF)
This refers to a sale in which the buyer pays a unit price which includes the FOB value plus
all costs of insurance and transportation. In effect this means that the seller delivers to the
buyer.
In many cases CIF delivery means that the buyer accepts the quality and quantity of the
commodity or energy product at the loading point rather than paying at the unloading port
for the delivery. However, it is a negotiable contract condition and the quality and quantity
are accepted by the buyer on discharge of the cargo.
The seller must provide insurance for the cargo although the risk and the title for the
commodity are transferred to the buyer at the loading port. A variation of CIF is where the
terms are just for Cost and Freight with no insurance – this is abbreviated to C+F or CFR.
Free Along Side (FAS)
This is very similar to FOB except that the seller’s responsibilities cease when the
commodity is brought alongside the vessel. In other words the seller is not responsible for
loading the commodity onto the vessel.
Alternative Delivery Procedures (ADPs)
For delivery conditions specified in a contract to be altered provided both buyer and seller
agree. Both parties may agree to a commodity delivery of a different standard, to a different
location and by a different method than that originally specified.
Exchange of Futures for Physicals (EFPs)
On exchanges such as the ICE and NYMEX it is possible to exchange a position in the futures
markets with an equivalent position in the physical markets.
Appendix
List of Derivative Exchanges and types of Derivatives listed in the Exchange.
Derivatives.xlsx
57

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Overview Derivatives

What are Derivatives?

There are four main types of derivatives traded today which:

Why have Derivatives?

Fortunes can be made and lost trading derivatives!

How are Derivatives traded?

 On an exchange floor using open outcry

Automated matching systems:

There are three characteristics of an automated matching system:

 Users send their bids and offers to a central matching system

Exchange traded OTC

These are the:

 Spot, cash or physical markets

Spot, cash or physical markets:

A forward contract can be summarised as follows:

Forward price = Spot or cash price + Cost of carry

A forward contract can be summarised as follows. Forward contracts are:

 Binding and non-negotiable

• The quality of the grain

• Commodity futures contracts

Commodity futures comprise the following contracts based on:

• Softs – Cocoa, Coffee, Sugar, Orange juice

Financial futures comprise the following contracts based on:

• Currency exchange rates

Trading on margin is an example of gearing or leverage. Gearing allows market players to

Who uses futures contracts?

• Accepting/rejecting cash offers for a commodity

Position For the same contract month Commodity or asset delivery

Initial Buy futures contract Agree to take

To off-set Sell futures contract Agree to make

Result Positions cancel = Close out Positions cancel = Close out

Commodity and Energy futures contracts

There are three broad types of financial futures as follows:

OTC v Exchange traded derivatives

What are options?

The following chart summarises options in terms of buyers/holders and sellers/writers.

There are three types of option writers using the markets:

How options work

The premium of an option has two components:

Premium = Intrinsic Value + Time Value

Intrinsic Value = Difference between strike and underlying prices

Intrinsic Value = Underlying price – Strike price

Time Value = Premium – Intrinsic Value

Interest Rate Swaps (IRSs)

 An IRS is an exchange or swap of interest rate payments calculated according to

A Currency swap is an agreement between counterparties in which one party makes

 A Currency swap usually involves an exchange of currencies between counterparties

A Commodity swap is an agreement between counterparties in which at least one set of

 A Commodity swap is usually a plain vanilla agreement which is purely financial

Supply, demand and the weather

This tends to be a major consideration for agricultural commodities. Adverse weather

Events such as international wars and action taken by individual governments in an

Availability and cost of labour

What are they?

What are hard and agricultural commodities?

How do the physical markets work?

The most important soft commodities traded worldwide are:

Grains and Oilseeds

The energy markets considered here are as follows:

Petroleum and its products

Electricity is known as a flow commodity because it cannot be stored in the conventional

Overview of the functioning of wholesale power markets

Tick size for a $0.01/MWh price fluctuation:

EEX Derivatives Market: