ENERGY DERIVATIVESEcon 3385 Economics of Energy

S. Grcan Glen, Ph.D.

Cash MarketsConduct Normal Business ActivityFace RisksPrice Risk Management Using Derivatives

ForwardsOptions - SwapsOrganized Exchanges

Futures - Options - SwapsOTC

MarketsPrice an indicator of the relative balance between the supply of and the demand for a particular product or commodity.Commodity a product over which the producer has lost control of the price.Derivative a product whose price is derived from the price of something else, which is referred to as the underlying commodity.

MarketsSpot Market Immediate Physical Delivery and immediate payment

Derivative Markets Deferred Physical Delivery Financially Settled ArrangementsEconomic Purpose Hedging Price discovery

Risk and Risk Management: Strategic ImplicationsWhat is risk management?Active identification and unbundling of the risks (exposures) a company faces in order to profit from exposures a company is well equipped to handle and mitigate potential losses from other risks.What is strategic risk management?Use of risk management to alter fundamentally a companys equity valuation through optimizing capital structure, enhancing risk/return profile of companys businesses and facilitating profitable pursuit of new opportunities.Derivatives A set of tools- forwards, futures, options, swaps and enhanced vehicles - that allow management to keep and add to those risks it seeks, and to shed those risks it chooses not to bear. These tools, which are traded in financial markets, allow management to focus on its core competencies in pursuit of its principal goal - maximizing returns while minimizing the variance of those returns. They are only part of the risk management tool set, along with operational efficiencies, competitive strategy, and so on.

MarketsRequisites for a Futures Market

Characteristics of the underlying cash commodity

Price Volatility Active marketOpen market (no government controls)

Price TheoryForward Curve

The price of a commodity over time.Two different shapes:

Contango

Backwardated

Price TheoryFutures v. Cash Prices

If the futures price is greater than the cash price, then:

Futures Price = Cash Price + Storage

Price TheoryContango

Price

time

Forward prices are successively higher over timeTodays price is the lowestCurrent supply exceeds demand

Price TheoryFutures v. Cash Prices

If the cash price is greater than the futures price, then: Futures Price = Cash Price + Storage - Convenience Yield

Price TheoryBackwardation

Price

timeForward prices are successively lower over timeTodays price is the highest Current demand exceeds supply

816 seats, 749 individual membersNYMEX MembershipCOMEX Membership772 seats, 663 individual members

ExecutivecommitteeBoard of DirectorsChairmen of the Board PresidentPlanning &developmentComplianceClearingMarketSurveillanceFinancial surveillance Trade SurveillanceStrategic PlanningResearchMarketingBanking & DelveriesPosition processingNYMEX Organization

Characteristics:LiquiditySafetyFlexibilityIngenuityFutures Exchange

Futures ExchangeForwardA bilateral commitment to buy or sell an agreed upon asset for a predetermined price on a specific future date.

FuturesA standardized forward contract which is traded on an organized futures exchange.

Futures ExchangeStandard Contract Terms

Size Quality Point of Delivery Time of Delivery Payment Disputes

Futures ExchangeVariable Contract Terms

Price

Number of contracts orders

Delivery Month

Futures ExchangeRules of Operation

Times and days of business Position limits Daily price limits Margin requirements Delivery procedures Payment Disputes

97%-98% OF ALL FUTURES ARE NOT DELIVERED

in other words:

ONLY 2%-3% OF THE CONTRACTS TRADED ARE DELIVERED!

EXAMPLE:IN 1990: 719,000 CRUDE OIL NYMEX CONTRACTS WERE ACTUALLY DELIVERED OUT OF 23 MILLION: ABOUT 3.126% QUESTION: WHAT DOES THIS MEAN?ACTIVITIES IN THE FUTURES MARKETS ARE MOSTLY FOR PURPOSES OTHER THAN PURCHASE AND SALE OF COMMODITY: FINANCIAL GOALS AND RISK MANAGEMENT GOALS.

QUESTION: HOW IS IT POSSIBLE FOR 98% OF EXISTING CONTRACTS TO DISAPPEAR?

ANSWER: THE CLEARINGHOUSE REGULATION AND ACCOUNTING METHODS.

THE CLEARINGHOUSE

A NON-PROFIT MEMBERSHIP CLUB. THE CLEARINGHOUSE IS THE OMNIPOTENT GUARANTOR OF ALL CONTRACTS.

* CLEARINGHOUSE GURANTEE: TO THE LONG - NO DEFAULT ON THE SELLING SIDE. TO THE SHORT - NO DEFAULT ON THE BUYING SIDE.

* THE CLEARINGHOUSE DOES NOT GURANTEE THE MARKET !

* THE CLEARINGHOUSE NEVER TAKES A POSITION.

* THE CLEARINGHOUSE MAKES SURE THAT ALL TRADES MATCH. I.E., THAT ALL THE POSITIONS MUST ADD UP TO ZERO EVERY TRADING DAY.

ClearinghouseExchangeCorporationFuturesCommissionMerchants(FCMs)FCM Customers

Exchange Members Clearing Members Nonclearing Members

Futures ExchangeTypes of Positions

Long - a commitment to buy; benefits if prices rise

Short - a commitment to sell; benefits if prices fall

Buyer SellerMember FirmMember FirmBuying FloorBroker Selling Floor BrokerTrading Ring

Orders executed by open outcry by buying and selling floor brokers, recorded and placed on ticker Buying:floor broker confirms purchase Selling: floor broker confirms sale Member firm Member firm Reports purchase Reports saleConfirmspurchaseConfirms sale Buyer now long 1 contract Seller now short 1 contract ClearinghouseTotal open interest: 1 contract 1obligation long 1obligation short

Seller - long with obligation to pay for and take delivery Member FirmMember FirmSelling FloorBroker Buying Floor BrokerTrading Ring

Orders executed by open outcry by buying and sellingfloor brokers, recorded and placed on ticker Sellingfloor broker confirms purchase Buying floor brokerconfirms sale Member firm Member firm Reports sale Reports purchaseConfirms saleConfirmspurchase Buyer has offset obligation by sale no market position Seller has offsetobligation by purchase -no market position ClearinghouseTotal open interest: 0 contract1 Obligationor long soldcancelingbuy obligation1 Obligationor short purchased canceling sellobligationBuyer - short with obligation to deliver

Futures ExchangeIntention to Make deliveryIntention to Accept DeliveryClearinghouse MatchesSeller with BuyerSellerBuyerDelivery ProcedureDeliveryPaymentShortLongClearingBrokerClearingBrokerDeposits full marginDeposits margin

Futures ExchangeMargins

Initial Margin A cash deposit

Variation Margin A margin call

A BCDEOutside CustomersFCM aFCM bFCM c Clearing member 1

Clearingmember 2......Clearinghouse BClearinghouse ACustomer marginsClearing margins

Futures ExchangeInitial Margin Requirements

NYMEX $/ContractCrude Oil2,200Heating Oil2,000Gasoline2,000Natural Gas6,300 * / 4,000Electricity1,900

+ Effective January 7, 1997 * for the Feb and Mar contracts only

Futures ExchangeMarking-to Market

The process that realizes all gains and losses.

Settlement Price

The benchmark against which all accounts are marked-to-market.

Futures ExchangeMarking-to-Market

Example: Transaction SettlementCommodity Price Price Change

Gasoline64.0065.501.50+Heating Oil58.0056.002.00+Gasoline66.0065.500.50-Crude Light25.6025.500.10-Electricity21.0019.901.10+

JUNE WTI FUTURES (1,000 bbls PER CONTRACT)DATE PARTY NUM PRICE PARTY NUM PRICE OI*

Th.5.16 A:LONG 10 $20 CH B:SHORT 10 $20 10

5.16 C:LONG 25 $21 CH D:SHORT 25 $21 35

5.16 SETTLE $21 $21

Fr.5.17 E:LONG 10 $22 CH A:SHORT 10 $22 35

5.17 SETTLE $22 $22

Mo.5.20 D:LONG 25 $22.5 CH F:SHORT 25 $22.5 35

5.20 B:LONG 10 $21.5 CH C:SHORT 10 $21.5 25

5.20 SETTLE $21.5 $21.5

Tu.5.21 F:LONG 10 $21 CH E:SHORT 10 $21 15

5.21 SETTLE $21 $21

We.5.22 F:LONG 10 $20 CH C:SHORT 10 $20 5

5.22 SETTLE $20 $20

* OI = Open Interest

CLEARINGHOUSE ACCOUNTING

A: LONG 10; SHORT 10 : OUT

B: SHORT 10; LONG 10 : OUT

C: LONG 25; SHORT 10; SHORT 10

C remains LONG 5.

D: SHORT 25; LONG 25 : OUT

E: LONG 10; SHORT 10 : OUT

F: SHORT 25; LONG 10 : LONG 10

F remains SHORT 5.5.23 F DECIDES TO DELIVER 5 FUTURES C ACCEPTS DELIVERY OF 5 CONTRACTS.The actual delivery is now scheduled for June 23.

CLEARINGHOUSE PROFIT/LOSS = ZERO*

LONG PRICE SHORT PRICE TOTAL PROFIT

A 10 $20 10 $22 $20,000

B 10 $21.5 10 $20 -$15,000

C 10 $21 10 $21.5 $5,000

10 $20 -$10,000

D 25 $22.5 25 $21 -$37,500

E 10 $22 10 $21 -$10,000

F 10 $21 25 $22.5 $15,000 10 $20 $25,000

TOTAL -$7,500

C TAKES DELIVERY 5 PAYS $21 : -$105,000 F DELIVERS 5 RECEIVES $22.5 : $112,500 $7,500TOTAL 0

* This calculation accounts for buying and selling only. It does not account for cash movements resulting from the daily marking-to-market process.

The following exhibits illustrate the activity in the margin account of each of the traders focusing only on cash flow resulting from the daily marking-to-market process. Thus, possible margin calls are ignored.

PARTY A:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.16 LONG 10 $20 Initial margin LONG 10 $21 +$10,000 LONG 105.17 SHORT 10 $22 +$10,000 0 TOTAL $20,000

As profit is = $20,000

PARTY B:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.16 SHORT 10 $20 Initial margin SHORT 10 $21 -$10,000 SHORT 105.17 $22 -$10,000 SHORT 105.20 LONG 10 $21.5 +$5,000 0 TOTAL -$15,000

Bs loss is = $15,000

PARTY C:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.16 LONG 25 $21 $21 Initial margin LONG 255.17 $22 +$25,0005.20 SHORT 10 $21.5 -$5,000 $21.5 -$7,500 LONG 155.21 $20.5 -$15,000 LONG 155.22 SHORT 10 $20 -$5,000 $20 -$2,500 LONG 55.23 TAKE DELIVERY OF 5,000 BARRELS for $20/bbl -$100,000 0

Cs total loss up to and and including 5.22 is $10,000.

Note that the 5 contracts that were delivered has accumulated the following amount over the period:

5.17 (5,000)($1) = $5,0005.20 (5,000)(-$.5) = -$2,5005.21 (5,000)(-$1) = -$5,0005.22 (5,000)(-$.5) = -$2,5005.23 (5,000)(-$20) = -$100,000 Payment upon delivery

TOTAL.-$105,000

The five contracts have accumulated total payment of $105,000 (Note: $105,000/5,000 = $21/bbl).

PARTY D:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.16 SHORT 25 $21 Initial margin SHORT 25 $21 0 SHORT 255.17 $22 -$25,000 SHORT 255.20 LONG 25 $22.5 -$12,500 0 TOTAL -$37,500

Ds total loss is = $37,500

PARTY E:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.17 LONG 10 $22 Initial margin LONG 10 $22 0 LONG 105.20 $21.5 -$5,000 LONG 105.21 SHORT 10 $21 -$5,000 0 TOTAL -$10,000

Es total loss is = $10,000

PARTY F:

DATE ACTION PRICE SETTLE CASH FLOW POSITION

5.20 SHORT 25 $22.5 Initial margin SHORT 25 $21.5 +$25,0005.21 LONG 10 $21 +$5,000 $20.5 +$15,000 SHORT 155.22 LONG 10 $20 +$5,000 $20 +$2,500 SHORT 55.23 DELIVER 5,000 BARRELS for $20/bbl +$100,000 0

Fs total profit up to and including 5.22 is $52,500.

Note that the 5 contracts that were delivered has accumulated the following amount over the period:

5.20 (5,000)($1) = $5,0005.21 (5,000)($1) = $5,0005.22 (5,000)($.5) = $2,5005.23 (5,000)($20) = $100,000 Payment upon delivery

TOTAL..$112,500

The five contracts that F delivers accumulated a total of $112,500 (Note: $112,500/5,000 = $22.5/bbl)

Futures TradingThe Trading Participants

Hedgers

Speculators

Arbitrageurs

Futures TradingSpeculationA transaction whose sole purpose is to achieve gain. A speculative transaction can be consummated in any market.Speculators (scalpers, day traders, position traders) Volatility sensitive Many transactions Short-term trades (seconds to days)

Futures TradingExample of Speculation (long and short)

Outright Position Price Action .

Pe uplong 10 Mar COB @ $11.00

Pr downshort 10 Mar COB@ $10.25

loss $0.75 / MWHr

Pe upshort Apr PV @ $16.00

Pr downlong 50 Apr PV @ $14.25profit $1.75 / MWHr

Futures TradingExample of Speculation (long and short)

Spread Position Price difference either widens or narrows:

Price Action .

Pe widened long 25 Dec NG short 25 Jun NG@ $0.35

Pr widenedshort 25 Dec NGlong 25 Jun NG @ $0.45

Pe narrow short 10 May HU long 10 May HO@ 2.00 cpg

Pr widenedlong 10 May HUshort 10 May HO@ 2.75cpg

HedgingPrimary Goals: reduce or eliminate price risk lower expected transaction costs reduce the probability of bankruptcy reduce expected tax liabilitiessignal to creditors that the firm is saferHedger Price level sensitive Few transactions Long-term trade (weeks or months)

HedgingTypes of Hedge Positions

Long Hedge A long derivative position ( benefits if prices rise )

Short Hedge A short derivative position ( benefits if prices fall )

HedgingLong Hedge

ActionCashFuturesnow Sell cashlong futureslaterbuy cashshort futuresP LOSS GAINP GAINLOSS

HedgingLong Hedge - Anticipatory

ActionCashFuturesnownothinglong futureslaterbuy cashshort futuresP 0 GAINP 0LOSS

HedgingLong Hedge - Fixed Price Prices Prices Action Increase Decrease sales price $28.00 $28.00

establish long hedge25.0025.00conclude physical purchase29.0024.00close hedge position29.00 -24.00 -Effective Purchase Cost $25.00 $25.00Margin $ 3.00 $ 3.00Gain or loss on futures $ 4.00 $ 1.00 -Gain or loss on cash $ 1.00 - $ 4.00

HedgingLong Hedge - Floating Pric Prices Prices Action Increase Decrease

establish long hedge $25.00 $25.00conclude physical purchase26.0024.00close hedge position26.00-24.00-Effective Purchase Cost $25.00 $25.00Gain on Futures $ 1.00Loss on Futures $ 1.00

LONG HEDGE

LDC PERSPECTIVE

An LDC has to buy 10,000 MMBtu a day or 300,000 MMBtu a month to supply residential customers and is concerned about rising natural gas prices. Therefore, the LDC decides to hedge its purchases by buying natural gas futures to lock inthe purchase price of December natural gas or execute a LONG HEDGE.

Note: 10,000 MMBTU = 1 NYMEX contract for natural gas 300,000 MMBTU = 30 contracts

Step 1: In August, it buys 30 contracts of December natural gas futures at an average price of $2.662 per MMBtu. The LDC now has a long position of 30 contracts.

Step 2: In late November, the LDC buys 300,000 MMBtu of natural gas from a marketer for $2.83 an MMBtu to meet its December demand.

Step 3: Simultaneously, the LDC liquidates the futures hedge or offsets the long position by selling futures. (The hedge was originally initiated by buying futures) The LDC sells 30 contracts on NYMEX for an average price of $2.83 since prices have risen as the LDC anticipated.

FUTURES:

($2.662) Long hedge average price per MMBTU 2.380 futures sold at current price 0.168 hedge gain

PHYSICAL:

$2.83 purchase price per MMBTU-( .168) futures gain 2.662 Final adjusted price to the LDC

LONG HEDGE

UTILITY PERSPECTIVE:A utility in the west who uses natural gas to produce electricity is notified by its supplier that due to a pipeline maintenance outage in July, alternate routing will be needed to deliver the gas at an increased cost. This renders natural gas uneconomic as power generation fuel. The utilitys trader decides to buy from Power Marketer X a 25 MW block of firm, on-peak (6-by-16) electrical energy in order to meet its anticipated load requirements, but naturally is very concerned about rising electricity prices. Therefore, the utility decides to hedge this purchase by buying July futures, or executing a long hedge, to lock in the purchase price of the electricity.

Jul power purchase = 25 MW *26 on-peak days * 16 on-peak hours per day = 10,400 Mwh1 NYMEX contract = 736 Mwh Contracts to hedge = 10,400 / 736 = 14.1 or 15 contracts

STEP 1 : Utility buys 15 Jul. futures contracts at an average price of $28.50 per Mwh. Utility now has a long position of 15 contracts.

STEP 2 : Utility now buys 10,400 Mwh of physical electricity from X Power Marketer for $28.80 per Mwh. Now, the utility needs to liquidate (or close out) the futures hedge (or long position) by selling futures. (Remember, the hedge was initiated by buying futures). Utility sells 15 contracts on exchange for average price of $28.80 Mwh, as prices have risen as anticipated by the trader. What is the utilitys final adjusted price?

FUTURES $28.50 Long Hedge futures average price - $28.80 futures sold at current price $ .30 Futures or hedge gain

PHYSICAL$28.80 Purchase from Power marketer - .30 hedge gain ( see above ) $28.50 Final adjusted price for utility

HedgingShort Hedge

ActionCashFuturesnowbuy cashshort futureslatersell cashlong futuresP GAIN LOSS P LOSSGAIN

HedgingShort Hedge - Anticipatory

ActionCashFuturesnownothingshort futureslatersell cashlong futuresP 0 LOSSP 0GAIN

HedgingShort Hedge - Fixed Price Prices Prices Action Increase Decrease purchase price $22.00 $22.00

establish short hedge25.00 -25.00 -conclude physical sale 29.00 -24.00 -close hedge position29.00 24.00Effective Sales Price $25.00 $25.00Margin $ 3.00 $ 3.00Gain or loss on futures $ 4.00 - $ 1.00 Gain or loss on cash $ 7.00 $ 2.00

HedgingShort Hedge - Floating Price Prices Prices Action Increase Decrease

establish short hedge $25.00 - $25.00 -conclude physical sale26.00 -24.00 -close hedge position26.0024.00Effective Sales Price $25.00 $25.00Loss on Futures $ 1.00Gain on Futures $ 1.00

SHORT HEDGE

INDEPENDENT POWER PRODUCER PERSPECTIVE:

The bulk power sales manager has excess power for the next two months and is concerned about falling prices in the forward market. The current futures market price would provide a profitable return for power plant operations. After reviewingsales commitments and forecasted operating conditions with her schedulers, the sales manager realizes there is available capacity. Therefore, in order to lock in the current price of the electricty, the independent power producer decides to sell theexcess power equivalent in the futures market by executing a short hedge. If the forward price for power continues to fall, the futures hedge will be offset as needed when the physical power is sold.

736Mwh = 1 futures contract 7,360Mwh = 10 futures contract

STEP 1 : Sell 10 Palo Verde futures contracts at an average price of $24.50 per Mwh. Producer now has short position of 10 contracts.

STEP 2 : Producer now sells 7,360Mwh of its excess power of to Wooly Navel Citrus Juice Company for $24.10 per Mwh. Now, the producer needs to offset, or liquidate, the short hedge by buying futures. Remember -- the producer is hedged with a short futures position. Producer buys 10 futures contracts at the average price of $24.10 per Mwh as prices have fallen as anticipated by the bulk power sales manager.

FUTURES$24.50 Short Hedge futures average price- 24.10 Futures purchased at current price$ .40 Futures or hedge result

PHYSICAL$24.10 Sale to Customer+ .40 Hedge result ( see above )$24.50 Final adjusted price for power producer

HedgingHedging - Spreads Calendar Spreads Intermarket Spread

HedgingIntermarket Spreads Crack Spread (gasoline, heating oil and crude oil) Spark Spread (electricity and natural gas)

NYMEX SPARK SPREAD

A specialized form of intermarket spread between natural gas and electricity

Involves the simultaneous purchase and sale of natural gas and electricity futures contracts

Protects or locks in a margin for current or future generation.

OptionsOption

A contingent claim.

Two Types of Options

Calls Puts

OptionsOption Buyer (holder or long)

In exchange for making a payment of money (the premium), the owner (buyer) of an option has the right, but not the obligation, to buy (call option) or to sell (put option) a specified quantity of the underlying commodity at a specified price at a specified time in the future.

OptionsOption Seller (writer or short)

In exchange for receiving a payment of money (the premium), the writer (seller) of an option has the obligation to provide (call option) or receive (put option) a specified volume of the underlying commodity at a specified price at a specified time in the future.

OptionsBuyer of a call option. . . expects the price of the underlying commodity to increase during the period of the option contract.

OptionsSeller of a call option. . . expects the price of the underlying commodity to either remain at the current level or to decline during the period of the option contract.

OptionsBuyer of a put option. . . expects the price of the underlying commodity to decrease during the period of the option contract.

OptionsSeller of a put option. . . expects the price of the underlying commodity to either remain at the current level or to increase during the period of the option contract.

OptionsTypes of Options American Option exercisable any time before expiration

European Optionexercisable only on expiration date

Average Rate Optionprice of underlying set by an averaging procedure

OptionsAt-the-money Whenever the price of the underlying is the same as the strike price of the option.In-the-money Whenever the price of the underlying is above the strike price of a call option or below the strike price of a put option.Out-of-the-money Whenever the price of the underlying is the below the strike price of a call option option or above the strike price of a put option.

OptionsOption Price = Premium

Two Components

Intrinsic Value - The amount by which an option is in-the-money.

Time Value - The amount by which the price of an option exceeds its intrinsic value.

OptionsOption Variables

Premium Strike Price= E Underlying Commodity= U Time Until Expiration= T Volatility= Interest Rate=

OptionsPut-Call Parity

C - P = U - E

where:

C = Call PremiumP = Put PremiumU = Price of the Underlying commodityE = Exercise or Strike Price of the Option

OptionsSynthetic Options

Call -Put = Synthetic LongPut + Underlying = Synthetic CallCall- Underlying = Synthetic PutPut - Call = -Synthetic Short-Put- Underlying = -Synthetic Call-Call+Underlying= -Synthetic Put

Business is conducted in the cash markets which is where materials, products and commodities are bought and sold everyday. Businesses face a multitude of risks, such as price risk (will prices move up or down), performance risk (will the customer accept delivery of the product or will the supplier provide the raw material), credit risk (will the customer pay), operational risk (will the factory or the people work as planned), liquidity risk (will there be a market for the product), government risk (will the rules of the game change), and systemic risk (will an event cascade through the economy). Businesses can construct tactics to deal with all of these risks. The goal is to control the level and the type of risk exposure a business is willing to accept.

The key point of this program is Price Risk Management. What is Price Risk Management? Price Risk Management addresses two concerns:1. Prices are uncertain, that is, will prices move up or down, and2. Prices are volatile, that is, what is the magnitude by which prices will move up or down. To manage price risk, there are a number of contractual arrangements available, that are financially settled, which allow a firm to pro-actively address their price risk exposure. These financially settled arrangements are part of a broader set of contractual arrangements called derivatives. Derivatives are part of what we call the Financial Markets.

Price is the amount of money necessary for the ownership of a commodity to change hands.

Value is the worth of something, which is usually expressed in monetary terms. It is also the intrinsic or economic worth of a product or commodity

if Price > Value ----> Sell the commodity if Price < Value ----> Buy the commodity

Characteristics of a commodity product: Homogeneous; very difficult to differentiate the product itself. Large number of buyers and sellers, neither of which, during the long run, can influence the price of the product. New firms can quickly and easily enter the market and existing firms can just as quickly and easily leave.

Derivative products are forwards, futures, options, and swaps.

The spot market is the market for commercial activity that results in the immediate delivery and immediate payment of a particular product or commodity.In the energy markets immediate payment = 30 days

The derivative market is the commercial activity that results in either the deferred delivery of a particular product or commodity, or in the financial settlement of a contractual arrangement.

Instruments:ForwardsFuturesOptionsSwaps

Price volatility means that, over time, prices are subject to relatively significant fluctuations.

An active market means that a large number of participants are interested in knowing the price for a particular product or commodity.

An open market means that the price of the commodity is free to respond to changing supply and demand conditions, (as well as psychological factors of fear and greed) and the ability to deliver the product or commodity is not impaired by rules or regulations.

A forward curve is a graph or table depicting the commodity prices for delivery at increasing time intervals.Contango and Backwardated describe the shape of the forward curve.

A contango curve is up-sloping over time.

A backwardated curve is downsloping over time.If the forward or futures price is greater than the cash price, then the forward cash market price or a futures price would equal the current cash market price for that commodity plus the cost incurred to store the commodity from the present time until the agreed delivery time in the future. Algebraically,Ft1 = Ct0 + S

where:Ft1=Futures price at a point in time t1Cto=Cash price now, time t0S=Cost of storage, which would include the cost of delivery into storage, the cost of re-delivery from storage, the cost of residency while in storage, the cost of quality and quantity inspection (grading), and the time value of money.

This relationship can also be expressed as:S = Ft1 - Ct0which states that the price of storage is the difference between the futures price, at any point in time, and the current cash price. This difference, S, will increase or decrease with the markets perceived need for additional storage. If additional storage is needed, S will increase sufficiently to entice an owner ot under-utilized storage capacity to make the next increment of storage available to the market. If additional storage is not needed, then S will decline to zero.

If, as of today, tomorrow's price for a commodity is greater than the price that could be received for that commodity in todays cash market, then the demand for the commodity is greater tomorrow than it is today. If tomorrows demand for a commodity is greater than it is today, then those who demand the product tomorrow, rather than being willing to accept delivery today when it is available at a lower price, should pay the costs of storage. That is, if demand is greater tomorrow than it is today, the market will pay to move excess supply of the commodity from today to tomorrow, when it will be needed. Moving excess supply from today until tomorrow is accomplished by placing that excess supply into inventory. As the storage schemes become more elaborate, the amount of the price discount offered by sellers, wishing to place the commodity for prompt delivery, will increase until the excess supply is removed from the market. If the cash price is greater than the forward or futures price, then the forward cash market price or a futures price would equal the current cash market price for that commodity plus the cost incurred to store the commodity from the present time until the agreed delivery time in the future, less a convenience yield. Algebraically,Ft1 = Ct0 + S - CY

where:Ft1=Futures price at a point in time t1Cto=Cash price now, time t0S=Cost of storage, which would include the cost of delivery into storage, the cost of re-delivery from storage, the cost of residency while in storage, the cost of quality and quantity inspection (grading), and the time value of money. CY=The return to the holder of a physical commodity.

The amount of the convenience yield varies directly with the magnitude of the prompt demand for the product or commodity. As demand increases, the convenience yield becomes greater. When demand decreases, the convenience yield becomes smaller. When current supply is again balanced with current demand, there is no longer a need to pay a premium for prompt supply, and the convenience yield becomes zero.

If todays price for a commodity is greater than the price that could be received for that commodity by holding it until tomorrow, then the demand for the commodity is greater today than it is tomorrow. If todays demand for a commodity is greater than it is tomorrow, then those who demand the product today should be willing to pay a premium to receive delivery today rather than being willing to wait until tomorrow when it is available at a lower price. That is, if demand is greater today than it is tomorrow, the market will pay to advance supply of the commodity from tomorrow to today, when it will be needed. Advancing supply from tomorrow to today is accomplished by withdrawing the commodity from inventory. The amount of the price premium bid by buyers wishing prompt delivery of the commodity will increase until those holding the commodity in inventory are induced to sell. LiquidityAbility to trade futures and options contracts from 3 to 6 years out, with high level of trading activity (volume) and open interest.SafetyMarket, financial and trade safeguards are enforced to prevent market manipulation and anti-competitive activity in a regulated and anonymous marketplaceFlexibilitySpreads and strips make trading easier and more efficient (crack) spreads, crude oil (natural gas) strips, spark spreadsIngenuity-NYMEX ACCESSSM, the after-hours electronic trading system -New product development - coal futures, Permian Basin & Calgary (Alberta) natural gas futures contractsTo facilitate the buying and selling of futures contracts, all of the terms are standardized. As a result, participants know exactly the parameters of what they are buying or selling. Price is the only variable open to negociation when either buying or selling a futures contract.

Energy products that have futures contracts traded on organized futures exchanges in the United States.New York Mercantile ExchangeGasolineHeating oilCrude oilNatural GasElectricityKansas City Board of TradeNatural Gas Thesize, i.e. the number of units included in one futures contract, is one of the more critical variables. If it is too large, the value of the total contract will also be large and will be viewed as too risky. This will reduce liquidity and therefore the probable success of the futures contract. If it is too small, the value of the contract will also be small which could attract less-knowledgeable participants as speculators. This will increase the performance risk and therefore the probable credibility of the futures contract. In the energy complex, the contract size for one futures contract is initially chosen at a level that will result in a total contract value of about $20,000.

Quality specifications are established that will allow the greatest flexibility without compromising the integrity of the product. The goal is to maintain a fungible product.

The point of delivery is chosen to maximize industry participation. To accomplish this goal, a locus of cash trading is usually desired as the delivery point.

The time of delivery follows the custom of the industry, i.e., either a batch or a flow. A batch delivery is usually arranged during a time window (usually an agreed number of days) during the delivery month. This window is agreed between the buyer (the holder of the long position), the seller (the holder of the short position), and the operator of the facilities at the delivery point.

The payment terms follow industry custom.

Disputes are handled by specific committees established by the exchange.

When placing an order to buy or sell a futures contract, it is necessary to provide only four paramwters:

1. the underlying asset

2. the contract delivery month or months involved. 3. the number of contracts to be bought or sold.

4. the price at which the order is to be executed, the only variable that is negotiated.

Trading can only occur during specified days and times.

Position Limits is the maximum number of net contracts a person can hold at any one time. Hedgers, by substantiating a bigger need, by virtue of the scope and scale of their operations, can obtain an exemption from the established limits.

Daily Price Limits is the maximum bounds of how much the price of the futures contract being traded can fluctuate during any trading session.

Margin Requirements is the amount of money that must be initially established, as a good faith deposit for each futures contract bought or sold, and the conditions under which it must be replenished.

Delivery procedures stipulates the quality requirements of the products deliverable against the contract, as well as how and when acceptable delivery occurs.

Payment terms define how and when payment will be made.

Procedures to resolve any dispute is clearly delineated.

A long position --You own it. A long position benefits if prices rise.

A short position --You owe it. A short position benefits if prices fall.

Step One: On the first business day after the last trading day, both the Short and the Long file notices with the Clearinghouse of their respective intentions to make and accept delivery.

Step Two: The clearing house matches the Longs with the Shorts and notifies each Seller who is their Buyer and notifies each Buyer who is their Seller.

Step Three: On the business day prior to the start of delivery, each Seller presents a Notice of Clearance to each Buyer. This Notice advises that all arrangements are in place and delivery will commence as scheduled.

Step Four: The Long deposits the full value of the delivery with its Clearing Broker. The Short deposits a margin, as required by the Exchange, with its Clearing Broker.

Step Five: The Seller makes delivery and receives payment. The Buyer takes delivery and makes payment.The Clearinghouse is responsible for making sure that thereis a long position for every short position and vice-versa

The initial margin is a good faith cash deposit. The amount of the margin is determined by the Exchange. If prices become more volatile, the Exchange mayraise the amount of the initial margin to limit the amount of undue speculation. Generally, the amount of the initial margin is equal to the maximum daily price fluctuation for the contract being traded.

The variation margin is the process of restoring the amount of the money in the margin account to the initial level after an adverse price move. Because all gains or losses are realized daily (marking-to-market), money is either moved into or moved out of themargin account each day. If losses reduce the margin account balance below a specified maintenance margin amount, a margin call is initiated for the amount necessary to restore the account balance to the level of the initial margin.

The margin applicable to members is 110% and for non-members is 135% of the base margin, as established by the exchange.

Margin Examples:

A member buys 1 Heating Oil (HO) Futures Contract (42,000 gallons) today at 67.00 cents a gallon. The initial margin required to be deposited with the customers clearing broker is $2,200. The next day the price falls to 62.00 cents a gallon. The margin account stands at $100. The clearing broker will send the customer a margin call for $2,100. This amount will restore the margin account to the initial required level of $2,200.

A non-member sells 1 Crude Oil Futures Contract (1,000 barrels) today at $23.00 a barrel. The initial margin required to be deposited with the customers clearing member broker is $2,970. the next day the price rises to $24.50 a barrel. The margin account stands at $1,470. The clearing member broker will send the customer a margin call for $1,500. This amount will restore the margin account to the initial required level of $2,970.All exchange traded derivative contracts are marked-to-market at the close of each trading day. Marking-to-market is the process that realizes all gains and losses, at the end of each trading day. If the price movement on the day has been favorable (rising prices for a long position or falling prices for a short position), the amount of the resulting gain will be credited to the account. If the price movement on the day has not been favorable (falling prices for a long position or rising prices for a short position), the amount of the resulting loss will be charged to the account.

Net cash positions are moved among the clearing members account with the clearing house at the end of each trading day. Each clearing member then credits or charges each customers account with the amount of money equal to each days gains or losses. The benchmark for marking-to-market is the settlement price. The settlement price is the price that most fairly represents the value of the derivatives contract at the close of trading, which is determined by procedures established by each exchange. In general, the settlement price is the weighted average of the prices trading during the closing range, if a minimum volume test is met. Otherwise, the settlement price is based on inter-month price spreads from a contract month whose settlement price has met the volume test.

The closing range is an agreed time period, prior to the time trading ends, during which the settlement price will be determined. This time period is established by each exchange for each derivatives contract being traded.

At the end of every trading day, the Transaction Price is compared to the current Settlement Price.

If the transaction is a sale and the Settlement Price is below the Transaction Price, the variation is positive; if the Settlement Price is above the Transaction Price, then the variation is negative.

If the transaction is a purchase and the Settlement Price is above the Transaction Price, the variation is positive; if the Settlement Price is below the Transaction Price, then the variation is negative.

It is important to recognize that this is a zero sum game. For every winner, there is a loser; and for every loser, there is a winner. The net result of all transactions is zero.

Hedgers seek to reduce or eliminate price risk by transferring the risk to another party.

Speculators accept risk for expected profit.

Arbitrageurs maintain price parity by capitalizing on any price discrepancy.

Speculative and arbitrage activities adds liquidity to a market. Active trading by speculators and arbitrageurs: creates price quotations which enhances price discovery. increases competition for trades which reduces the bid-ask spread.provides a counterparty for hedgers

Speculators provide a useful service - liquidity. Without speculators, markets would be very erratic and price discovery would be very limited.

Speculators employ various means that, to the un-trained eye, essentially allows them to buy high and later sell low, or sell high and later buy low. Some of these means are:

Spreading - buying one commodity and simultaneously selling another;- buying one month and simultaneously selling another;- buying one option strike and simultaneously selling another.

The speculator expects the price of electricity to increase. A long position is established by buying 10 March electricity futures contracts (736 MWHrs each) at the California-Oregon Border (COB) at $11.00 / MWHr.

The expectation is not realized as the COB electricity futures price declined to $10.25 / MWHr. The speculator has suffered enough pain, and closes the position by selling 10 March COB electricity futures contracts at that level. The loss realized is $0.75 / MWHr or $ 5,520.

The speculator expects the price of electricity to decrease. A short position is established by selling 50 April electricity futures contracts (736 MWhrs each) at Palo Verde at $16.00 / MWHr.

The expectation is correct as the PV electricity futures price declined to $14.25/ MWHr. Achieving the price objective, the speculator closes the position by selling 50 April PV electricity futures contracts at that level. The profit realized is $1.75 / MWHr or $285,200. The speculator expects the price of the December natural gas futures contract to rise relative to the price of the June natural gas futures contract; the spread to widen. A long position is established by buying 25 December natural gas futures contracts (10,000 MMbtu each) at $3.05 / MM Btu and selling 25 June natural gas futures contracts (10,000 MMbtu each) at $2.70 / MM Btu, for a spread of $0.35 / MM Btu, December over June. The expectation is realized as the December - June natural gas spread widened to $0.45 / MM Btu. Achieving the price goal, the speculator closes the position by selling 25 December natural gas futures contracts and buying 25 June natural gas futures contracts. The gain realized is $0.10 / MM Btu or $25,000.

The speculator expects the price of the May gasoline futures contract to fall relative to the price of the May heating oil futures contract; the spread to narrow. A short position is established by selling 10 May gasoline futures contracts (42,000 gallon each) at 70.00 cpg and buying 10 May heating oil futures contracts (42,000 gallon each) at 68.00 cpg, for a spread of 2.00 cpg, Gasoline over heating oil. The expectation is not realized as the May gasoline - heating oil spread widened to 2.75 cpg. The speculator closes the position by buying 10 May gasoline futures contracts and selling 10 May heating oil futures contracts. The loss realized is 0.75 cpg or $315,000.

Hedging the commodity price risk associated with either a revenue stream or the cost of feedstocks or raw materials, as well as a demonstrated record of controlling operating costs, can result in a stable predictable stream of cash flows. If the firm was a borrower, this stabilized cash flow stream would reduce the lenders re-payment risk which could result in a lower borrowing rate. As a matter of fact, many financial institutions require potential borrowing clients to be hedged.

A stabilized stream of cash flows that raises the probability of satisfactory debt re-payment and continued growth of the firm also reduces the probability of bankruptcy and maintain access to adequate trade credit arrangements.

Hedging activities, by defining or fixing the price applicable to either a stream of revenues or costs, can also manage expected tax liabilities.

A long hedge position --a commitment to buy the commodity. Ultimately, you may own it. A long hedge position benefits if prices rise.

A short hedge position --a commitment to sell the commodity. Ultimately, may have to deliver it . A short hedge position benefits if prices fall.

If a user or consumer of a commodity product, or a marketer has pre-sold the commodity at a fixed price, but has yet to fix the price for the corresponding supply, and expects prices to rise in the mean time, that user, consumer, or marketer can go long futures contracts now to reduce this price risk exposure. Going long futures contracts now establishes a long hedge. When it is time to acquire the physical supply in the cash market, the user, consumer, or marketer would make those arrangements through the normal channels and then close the futures position, which is accomplished by going short futures. This transaction manages fixed price risk.

If a user or consumer of a commodity product needs to buy the commodity at some future date, but expects prices to rise in the mean time, the user or consumer can buy futures contracts now. Going long futures contracts now establishes a long hedge, which reduces the price risk exposure. When it is time to acquire the physical supply in the cash market, the user or consumer would make those arrangements through the normal channels and then close the futures position. The long hedge position is closed by going short futures. This hedge transaction manages floating price risk.

If a user or consumer of a commodity product, or a marketer has pre-sold the commodity at a fixed price of $28, but has yet to fix the price for the corresponding supply, and expects prices to rise in the mean time, that user, consumer, or marketer can go long futures contracts now to reduce this price risk exposure. Assuming the futures price is $25, a long hedge is established at this level. At a later time, the user or consumer concludes a purchase in the cash market at $29.00, in the Prices Increase case and $24.00 in the Prices Decrease case. When this transaction is completed, the user or consumer liquidates the hedge position by going short futures at the same price level as the cash purchase, which assumes no basis risk. The effective purchase cost of the commodity is the price at which the hedge is established, as the higher cost of the cash market purchase, in the Prices Increase case, is offset by the gain on the futures hedge. Similarly, the lower cost of the cash market purchase, in the Prices Decrease case, is offset by the loss on the futures hedge. The trading margin is determined when the hedge is established. This margin is the same as the net result of the gain or loss on the futures transactions coupled with the gain or loss on the cash transactions.

The effective purchase cost is the cash market equivalent price to the futures price when the long hedge was established. Assume the futures price and the cash market price are the same, i.e., no basis.

If a user or consumer of a commodity product needs to buy the commodity at some future date, but expects prices to rise in the mean time, the user or consumer can go long futures contracts now. Assuming the price of the commodity is $25.00, the user or consumer establishes a long hedge at this level. At a later time, the user or consumer concludes a purchase in the cash market at $26.00, in the Prices Increase case and $24.00 in the Prices Decrease case. When this transaction is completed, the use or consumer liquidates the hedge position by going short futures at the same price level as the cash purchase, which assumes no basis risk. The effective purchase cost of the commodity is the price at which the hedge is established, as the higher cost of the cash market purchase, in the Prices Increase case, is offset by the gain on the futures hedge. Similarly, the lower cost of the cash market purchase, in the Prices Decrease case, is offset by the loss on the futures hedge.

The effective purchase cost is the cash market equivalent price to the futures price when the long hedge was established. Assume the futures price and the cash market price are the same, i.e., no basis.

If a user or marketer of a commodity product, has pre-purchased the commodity at a fixed price, but has yet to fix the price for the corresponding sale, and expects prices to fall in the mean time, that user or marketer can go short futures contracts now to reduce this price risk exposure. Going short futures contracts now establishes a short hedge. When it is time to sell the physical supply in the cash market, the user or marketer would make those arrangements through the normal channels and then close the futures position, which is accomplished by going long futures. This transaction manages fixed price risk.

If a producer of a commodity product needs to sell the commodity at some future date, but expects prices to fall in the mean time, that producer can go short futures contracts now. Going short futures contracts now establishes a short hedge, which reduces the price risk exposure. When it is time to sell the physical supply in the cash market, the producer would make those arrangements through the normal channels and then close the futures position which is accomplished by going long futures. This transaction manages floating price risk.

If a producer of a commodity product, or a marketer has pre-purchased the commodity at a fixed price of $22, but has yet to fix the price for the corresponding sale, and expects prices to fall in the mean time, that producer or marketer can go short futures contracts now to reduce this price risk exposure. Assuming the futures price is $25, and a short hedge is established at this level. At a later time, the producer concludes a sale in the cash market at $29.00, in the Prices Increase case and $24.00 in the Prices Decrease case. When this transaction is completed, the producer liquidates the hedge position by going long futures at the same price level as the cash sale, which assumes no basis risk. The effective sales price of the commodity is the price at which the hedge is established, as the higher price of the cash market sale, in the Prices Increase case, is offset by the loss on the futures hedge. Similarly, the lower price of the cash market sale, in the Prices Decrease case, is offset by the gain on the futures hedge. The trading margin is determined when the hedge is established. This margin is the same as the net result of the gain or loss on the futures transactions coupled with the gain or loss on the cash transactions.

The effective sales price is the cash market equivalent price to the futures price when the short hedge was established. Assume the futures price and the cash market price are the same, i.e., no basis.

If a producer of a commodity product needs to sell the commodity at some future date, but expects prices to fall in the mean time, the producer can go short futures contracts now. Assuming the price of the commodity is $25.00, the producer establishes a short hedge at this level. At a later time, the producer concludes a sale in the cash market at $26.00, in the Prices Increase case and $24.00 in the Prices Decrease case. When this transaction is completed, the producer liquidates the hedge position by going long futures at the same price level as the cash purchase, which assumes no basis risk. The effective sales price of the commodity is the price at which the hedge is established, as the higher price of the cash market sale, in the Prices Increase case, is offset by the loss on the futures hedge. Similarly, the lower price of the cash market sale, in the Prices Decrease case, is offset by the gain on the futures hedge.

The effective sales price is the cash market equivalent price to the futures price when the short hedge was established. Assume the futures price and the cash market price are the same, i.e., no basis.A spread is the differnce between two transactions, a long and a short, both concluded simultaneously.A calendar spread is the difference between a long transaction in one contract month and a short transaction in a different contract month. Long January crude oil and short February crude oil, or long May gasoline and short November gasoline are examples of calendar spreads. An intermarket spread is the difference between a long transaction in one contract a short transaction in a different commodity. Long December heating oil and short April crude oil, or long May Palo Verde electricity and short May COB electicity are examples of intermarket spreads.The character of a spread position is determined by what is done to the higher priced commodity.A long spread position is a commitment to buy the higher priced commodity and a simultaneous commitment to sell the lower priced commodity. The Palo Verde electricity futures contract is priced at $25/MWH and the March COB electricity futures contract is priced at $21.00/MWH, a long spread position would be to buy Palo Verde and sell COB.A short spread position is a commitment to sell the higher priced commodity and a simultaneous commitment to buy the lower priced commodity. If May gasoline is priced at 55 cents a gallon and the September heating oil contract is priced at 43 cents a gallon, a short spread position would be to sell the May gasoline and to buy the September heating oil.A crack spread is the single order for the purchase of crude oil futures contracts and the simultaneous sale of gasoline and heating oil futures contracts. The crack spread is based on the input to the refinery (crude oil) and the output (gasoline and heating oil). A typical example is 3:2:1. This is based on the input of 3 units of crude oil to produce 2 gasoline and 1 heating oil units.

A spark spread is the single order for the purchase of natural gas futures contracts and the simultaneous sale of electricity futures contracts. The spark spread is based on the energy efficiency of a power generation unit or a ratio of Btu to kWh output. Typical spark spreads are the 4:3 and the 5:3. These are based on 4 or 5 units of output for 3 units of input.

An option gives the holder (owner) (buyer) the right to buy, in the case of a call, or to sell, in the case of a put, a specified quantity of the underlying asset, at a predetermined price, during a specified time period in the future. At the end of this time period the option expires.

The writer (seller) of an option has the obligation, upon exercise of the option by the holder, to sell the underlying asset, in the case of a call option, or buy the underlying asset, in the case of a put option

The right inherent in an option has value. The money associated with this value is the price of an option, and is called the premium. The premium is paid by the buyer and collected by the seller. This is a distinguishing characteristic of options, when compared to forwards, futures, and swaps.

The option holder will exercise the option only if it is advantageous. Otherwise, the holder will let the option expire un-exercised (worthless). Thus, the loss to the buyer of an option is limited to the amount of the premium paid.

The gain to the buyer of a call option is theoretically unlimited, since there is no limit on how high the price can move above the Exercise or Strike Price. In the case of a put option, the maximum theoretical gain is limited to the difference between the Exercise or Strike Price and zero.

The gain to the seller of an option is, at most, the amount of the premium received. This occurs only when the option us un-exercised.

The loss to the seller of a call option is theoretically unlimited, since there is no limit on how high the price can move above the Exercise or Strike Price. In the case of a put option, the maximum theoretical loss is limited to the difference between the Exercise or Strike Price and zero.

At expiration, if the price of the underlying is above the strike price of the call option, the buyer will exercise the option. As a result of exercising, the buyer will accept delivery of the underlying (which is a futures contract in the case of on-exchange options), and pay the exercise or strike price. The gain to the buyer is the amount by which the sales price (current market price) exceeds the strike price, less the premium originally paid for the option.

At expiration, if the price of the underlying is below the strike price of the call option, the option will expire worthless. As a result, the buyer will have lost the premium; the amount of money originally paid for the option.

At expiration, if the price of the underlying is above the strike price of the call option, the buyer will exercise the option. As a result of exercising, the seller must make delivery of the underlying (which is a futures contract in the case of on-exchange options) and receive the strike price of the option.

At expiration, if the price of the underlying is below the strike price of the call option, the option will expire worthless. As a result, the seller will keep the premium; the amount of money originally received for the option.At expiration, if the price of the underlying is below the strike price of the put option, the buyer will exercise the option. As a result of exercising, the buyer will make delivery of the underlying (which is a futures contract in the case of on-exchange options), and receive the exercise or strike price. The gain to the buyer is the amount by which the exercise or strike exceeds the sales price (current market price), less the premium originally paid for the option.

At expiration, if the price of the underlying is above the strike price of the put option, the option will expire worthless. As a result, the buyer will have lost the premium; the amount of money originally paid for the option.At expiration, if the price of the underlying is below the strike price of the put option, the buyer will exercise the option. As a result of exercising, the seller must take delivery of the underlying (which is a futures contract in the case of on-exchange options) and pay the strike price of the option.

At expiration, if the price of the underlying is above the strike price of the put option, the option will expire worthless. As a result, the seller will keep the premium; the amount of money originally received for the option.

American Style Option -is traded on both organized exchanges and over-the-counter markets all over the world. The price for an American Style Option is higher than the European Style Option because of the provision for early exercise.

European Style Option -is traded on both organized exchanges and over-the-counter markets all over the world.

Average Rate Option -is traded on over-the-counter markets. The price of the underlying is determined by averaging the market price for the commodity over an agreed time period. This arrangement, generally used by firms engaged in a continuous manufacturing or processing activity, provides a better match between actual activity and managing price risk. CALLSPUTS

At-the-MoneyU = EU = E

An At-the-money option does not have intrinsic value.

Example: Electricity Futures (U) at $24.00

Strike (E)CallPut

21.00ITMOTM22.00ITMOTM23.00ITMOTM24.00ATMATM25.00OTMITM26.00OTMITM27.00OTMITM

Option Price or Premium = Intrinsic Value + Time Value

The intrinsic value of a call option is the positive difference between the current price of the Underlying and the Exercise or Strike Price of the option, (U - E). If the call option is either at-the-money or out-of-the-money, the intrinsic value is zero. Intrinsic value of a call option = Max { 0, (U - E) }

The intrinsic value of a put option is the positive difference between the Exercise or Strike Price of the option and the current price of the Underlying, (E - U). If the put option is either at-the-money or out-of-the-money, the intrinsic value is zero.Intrinsic value of a put option = Max { (E - U) , 0 }

When an option is trading either at-the-money or out-of-the-money, the option price or premium is all time value, since the price of the Underlying and the Exercise or Strike Price are both the same.

Premium - the price of the option.

Strike Price - the price at which the option can be exercised; the price at which the holder of an option is entitled to buy (call option) or sell (put option) the underlying commodity.

Underlying Commodity - the commodity on which an option is written. This can be either a futures contract or the physical commodity.

Time Until Expiration - the time period remaining during which the option arrangement can have value.

Volatility - a measure of the variability of the price of a commodity during a specified time period.

Interest Rate - the value of the alternative use of money.

The owner of an at-the-money call option will receive a payoff at expiration if the price of the underlying is at or above the current price, which is also the Exercise or Strike Price of the option.

The writer of an at-the-money put option will incur an obligation at expiration if the price of the underlying is at or below the current price, which is also the Exercise or Strike Price of the option.

If a person benefits at all prices above the current price and is obligated at all prices below the current price, this is the same risk profile as a long position in the underlying commodity. Therefore, the net result of a long call option and a short put option, both with the same Exercise or Strike Price is a Synthetic Long position in the underlying at the Exercise or Strike Price.

Call - Put = Synthetic Long

This basic equation can be solved for any variable, which would describe the components necessary to construct the synthetic instrument.