Chapter 5 Energy Derivatives: Structures and Applications (Book Review)

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Chapter 5Energy Derivatives Structures and
Applications(Book Review)

• Zhao, Lu (Matthew)
• Dept. of Math Stats, Univ. of Calgary
• January 24, 2007
• Lunch at the Lab Seminar

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Outline

• Exchange Traded Instruments
• Swaps
• Caps, Floors and Collars
• Swaptions
• Compound Options Captions and Floptions
• Spread and Exchange Options
• Path Dependent Options

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1 Introduction

• Exotic Options
• More complicated payoff structures than standard
  derivatives
• Known as second generation, or sometimes
  path-dependent options
• Trade over-the-counter (almost)

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2 Exchange Traded Instruments

• New York Mercantile Exchange (NYMEX)
• Futures and American style futures options on
  oil, gas and electricity crack spread options
• Chicago Board Options Exchange (CBOE)
• Electricity futures and options
• Sydney Futures Exchange and Nordic Electricity
  Exchange
• Electricity futures

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3 Swaps

• First energy swaps were traded in October 1986
  (Chase Manhattan Bank vs. Cathay Pacific Airways
  and Koch Industries, oil-indexed price swap)
• Swaps are also known as Contracts-for-Differences
  or Fixed-for-Floating contracts
• Used to lock in a fixed price for a certain
  predetermined but not necessarily constant
  quantity

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3.1 Vanilla Swap

• An agreement in which counterparties exchange a
  floating energy price for a fixed energy price
• Example
• Buyer an oil producer
• Swap provider an oil refiner
• A swap would allow them to buy forward their
  anticipated oil consumption based on current oil
  forward prices

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• Vanilla swaps can be priced directly off the
  forward energy curve since the appropriate
  portfolio of forward deals is an exact hedge of
  the swap. Therefore, the payoff at each reset
  date is the same as for a forward contract
• A vanilla swap is usually viewed as a weighted
  average of the forwards underlying the swap with
  weights being the discount rates to each of the
  swap settlement dates

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• The value of a vanilla swap

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3.2 Variable Volume Swap

• This contract is identical to a vanilla swap
  except that the underlying quantity or volume is
  not known in advance
• The variability of the volume must be modeled in
  order to price contracts (detailed in Chapter 7)

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3.3 Differential Swap

• Similar to vanilla swaps except that the
  counterparties exchange the difference between
  two different floating prices for a fixed price
  differential
• Example
• A refiners probability depends on the market
  price differential of the raw commodity and the
  refined products and a differential swap allows a
  refiner to lock in their refining margin at the
  fixed price

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• A differential swap is a portfolio of forward
  differential contracts with maturity dates
  corresponding to the settlement dates underlying
  the differential swap
• The value is given by

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3.4 Margin or Crack Swap

• A specific form of differential swap in which the
  fixed price payer receives the difference between
  the market price differential of the raw
  commodity and the refined products in appropriate
  fractions and the fixed price

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3.5 Participation Swap

• Similar to a vanilla swap in that the fixed price
  payer is fully protected when prices rise above
  the agreed fixed price but they participate in a
  certain percentage of savings if prices fall.
• Example
• A participation swap for gasoil at a fixed
  price of 150 per ton with a participation of 50
• a) If the gasoil price is 160 per ton, the
  fixed price payer received 10 per ton
• b) If the gasoil price is 140 per ton, the
  fixed price payer only pay the provider 5 per ton

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3.6 Double-Up Swap

• The fixed price payer can achieve a better swap
  price than the market price but in return the
  swap provider has the option to double the volume
  before the pricing period starts
• The fixed price payer is exposed to the risk that
  if swap prices fall the fixed price receiver will
  exercise the right to double the swap volume

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3.7 Extendable Swap

• Similar to the double-up swap except that the
  swap provider has the option to extend the period
  of the swap for a predetermined period

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4 Caps, Floors and Collars

• Caps provide price protection for the buyer above
  a predetermined level for a predetermined period
  of time
• Floors guarantee the minimum price that will be
  paid or received at a predetermined level
• A collar is a combination of a long position in a
  cap and a short position in a floor

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• A generic cap can be viewed as a portfolio of
  standard European call options with strike prices
  equal to the cap level and maturity dates equal
  to the settlement dates of the cap
• Value of a standard cap is given by

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• Similarly, a generic floor is a portfolio of
  European put options with strike prices equal to
  the floor level and maturity dates equal to the
  settlement dates of the floor
• Value of a floor is given by

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• Collars are typically used by energy buyers who
  wish to hedge against price increases and wish to
  use the premium on short floors to pay for the
  cap protection
• The strike prices of the cap and floor can be set
  to yield a collar at zero cost

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5 Swaptions

• A swaption is a European option on an energy swap
• A call option on the swap, also called a payer
  swaption, with strike price K and time to
  maturity T, provides the holder of the option the
  right to enter into a swap, paying the fixed
  price K and receiving the floating energy spot
  price
• A put option on a swap, or receiver swaption,
  gives the purchaser of the option the right to
  sell a swap or receive the fixed price K and pay
  the floating price

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• The payoff to the payer swaption as
• The value of the payer swaption is

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• If physical settlement considered
• Payoff
• Value

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6 Compound Options-Captions and Floptions

• An option which allows its holder to purchase or
  sell another option for a fixed price is called a
  compound option
• A caption is an option on a cap and a floption is
  an option on a floor
• These instruments are options on portfolios of
  options and no simple analytical formulae exist

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7 Spread and Exchange Options

• 7.1 Calendar Spreads
• If the futures contracts are written on the same
  underlying energy, but with different maturity
  dates, then the option is often referred to as a
  calendar spread option
• Payoff to a European call spread option with
  strike K and maturity T as

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• Value of the calendar spread option

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7.2 Crack Spreads

• If the futures contracts underlying the option
  are written on two separate energies, then the
  option is often referred to as a crack spread
  option. The maturity of the futures contracts can
  be on the same date or different dates
• Options of this type are often used by companies
  who are exposed to the difference in price
  between two different energies

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• Payoff
• Value

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7.3 Exchange Options

• Provide a payout which is based on the relative
  performance of two energy prices
• Two types
• a) out-performance options payoff
• b)

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8 Path Dependent Options

• 8.1 Asian Options-Average Price and Average
  Strike
• Asian options are options whose final payoff is
  based in some way on the average level of an
  energy price during some or all of the life of
  the option
• In general, the main use of Asian options is
  hedging an exposure to the average price over a
  period of time

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8.2 Barrier Options

• Barrier options are standard options that either
  cease to exist or only come into existence if the
  underlying price crosses a predetermined level
  the barrier
• Analytical formulae exist for the basic barrier
  options in the Black-Scholes-Merton world under
  the assumption that the crossing of the barrier
  is continuously checked. For discretely fixed
  barrier options we need to use numerical
  techniques to evaluate prices

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8.3 Lookback Options-Fixed Strike and Floating
Strike

• The payout of lookback options is a function of
  the highest or lowest price at which the
  underlying asset trades over some period during
  the life of the option. For this reason, they are
  occasionally referred to as hindsight options
• Analytical formulae exist for the standard
  lookback options in a Black-Scholes-Merton world
  when the maximum or minimum is checked
  continuously, but numerical techniques must be
  used for discretely fixed examples

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8.4 Ladder and Cliquet Options

• Ladder options have a predefined set of levels
  such that if the underlying price crosses a
  particular level it locks in a minimum payoff
  equal to the difference between the level crossed
  and the strike price

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• Cliquet options have a predefined set of dates at
  which the underlying price is observed and they
  payoff the maximum of the differences between
  these fixings and the predefined strike price for
  a call or the maximum of the differences between
  the predefined strike price and the fixings for a
  put

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9 Summary

• Exotic options are almost common place in the
  energy markets compared with other markets
• The high volatility exhibited by many energy
  commodities and the fact that they have been
  embedded in many energy contracts for a long time
  has led to a ready acceptance for these kinds of
  derivatives

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THE ENDTHANK YOU!