Derivatives Project
• Select a specific financial asset traded in a spot market (e.g., specific fixed income security, common stock, foreign exchange, or commodity contract).
• Select two or more derivatives as part of a trading strategy, (e.g., a speculative strategy, hedge, straddle, etc. that are combined into a portfolio. 
Assets that are selected must be available in the Bloomberg database accessed via the Bloomberg terminals.
This report is significantly focused on the specific financial asset that is traded in the spot market. The commodity selected is NYMEX WTI Crude Oil. Two or more derivatives would be selected as part of a trading strategy, (e.g., a speculative strategy, hedge, straddle, etc. that are combined into a portfolio. Hedging is the utilization of techniques related to investment to minimize risk within a portfolio. This could be possible by expert money managers and by individual speculators. There are numerous approaches to hedge, however it essentially is making a bet, trade or investment trying to shield a financial investor from potential losses in another speculation. So as to hedge effectively, the second venture must be in negative relationship to the original investment or trade. This implies that one speculation is creating returns that surpass those of the more extensive financial markets, and the other venture, which is the trade that is being placed to hedge; by and large it results in the generation of returns that are basically under the markets (Yun and Jae Kim, 2010).
Numerous investors utilize hedging in a portfolio to give a level of protection against potential losses and against surprising and undesirable shifts in price within the securities. Modern trading instruments and strategies, for example, derivatives that incorporate alternatives securities, are intended to give this layer of security. Options are financial instruments that, for a price, give speculators the privilege to purchase or offer a security at a given cost before the close date. These financial securities can be connected to a large group of diverse asset classes, including bonds, securities and additionally commodities among others (Loss, 2012). This report will focus on the most effective hedging strategies which are also fundamentally typical for almost all Gasoline companies. They are discussed as below:
It is a well-known fact that there are primarily 6 energy futures contracts where the four of them are traded on the NYNEX i.e. NY Harbor ultra-low sulfur diesel, RSOB gasoline New York Mercantile Exchange, WTI crude oil, and Henry Hub natural gas. A futures contract gives the purchaser of the contract, the obligation and debt, to purchase the underlying commodity at the cost at which he purchases the futures contract. Then again, a futures contract gives the contract seller, the obligation and right, to sell the fundamental commodity at the cost at which he offers the futures contract. On the other hand, practically speaking, there are only few commodity futures contracts really bring about delivery, most are used for hedging and are purchased or sold back preceding expiration. The Natural gas futures is illustrated below:
As a case, how about we accept that the researcher is a producer of natural gas who needs to undertake the hedging strategy for the price of natural gas generation within future. For purpose of simplicity, it should be accepted that one is looking to hedge (by locking or fixing the price) 10000 MMBtu of the production within June 2015. To support this production with respect to the futures, one would be selling one natural gas futures contract within June 15. On the off chance that one had sold this contract in view of the end cost on Friday, one would have supported 10,000 MMBtu of the June 2015 production at $2.839/MMBtu.
If it is assumed that that it is May 27, 2015, the closing date of the June 2015 futures contract for natural gas. Since one would prefer not to make delivery of the futures contract, followed by the buyback of one June natural gas futures contract at the prevailing price of the market (Dash and N.S., n.d.). To think about how the methodology will function if natural gas futures for June settle at prices both above and underneath the cost of $2.839, one should inspect the accompanying two situations.
In the first situation, if one expects that the prevailing price of the market, at which one buys back the futures contract for natural gas, is $3.089/MMBtu, which is $0.25 higher than the cost at which one sold the futures contract. In this situation, one would get more or less $3.089/MMBtu for the June 2015 production for natural gas production. Then again, the net value would be $2.839/MMBtu, the cost at which one initially sold the futures contract, barring the basis differential, transportation and gathering fees. This is on the grounds that one would bring about a loss of $0.25/MMBtu ($2.839 – $3.089 = $0.25) on the futures contract.
In the second situation, if it is assumed that the prevailing price for the market, at which one buys back the natural gas futures contract for June, is $2.589/MMBtu, which is $0.25 lower than the cost at which one sold the prospects contract. In this situation, the producer would get $2.589/MMBtu for natural gas production June 2015. Like the first situation, the net price would be $2.839/MMBtu, again barring the basis differential, transporting and gathering fees. This is on account of one would cause an addition of $0.25/MMBtu ($2.839 – $2.589 = $0.25) on the futures contract.
While there are various points of interest that need to be considered before you support your common gas generation with fates, the fundamental philosophy is fairly straightforward: in the event that you are a characteristic gas maker and need or need to fence your presentation to regular gas costs, you can do as such by offering a characteristic gas prospects contract (Fonseca and Rustem, 2012).
Another hedging strategy could be related to swaps. The commodity selected would be Brent Crude oil. Before discussing the trading strategy for this, it is quite necessary to discuss as to what is a swap. A swap is an agreement whereby a market price or floating price is traded at fixed cost or a fixed cost is traded at a skimming cost, over a predefined period(s) of time (Lautier and Galli, n.d.). The instrument is alluded to as a swap on the grounds that the transaction would include the sellers and buyers cash flows that are swapping with each other.
Swaps are ostensibly the most prevalent instrument related to hedging utilized by producers of oil and gas to support their introduction to volatile prices for gas and oil as hedging with swaps permits them to fix or lock in the price they get for their gas and oil production (de Ville de Goyet, n.d.). Notwithstanding organizations trying to hedge their exposure to the commodity prices of energy, swaps are additionally used by organizations looking to hedge their exposure for agricultural commodities, foreign exchange rates, metals, interest rates and others as well.
If the trading strategy in accordance with the swap is to be proposed to conduct a hedging strategy for the production of crude oil, then it should be assumed to hedge the July 2015 production for crude oil to guarantee that the revenue for July meets or surpasses the estimate for budget of $60.00/BBL. For the purpose of simplicity, it should be assumed that one is looking to hedge 10,000 barrels of the foreseen, July 2015 production. Keeping in mind the end goal to fulfill the objective, one could offer a 10,000 BBL July 2015 calendar swap for Brent Crude Oil July 2015 (Fonseca and Rustem, 2012). In the event that one had sold a July 2015 calendar swap for Brent Crude Oil last Friday the price would have been roughly $63.00/BBL.
Presently it should be investigated as to how hedging with this swap would affect the revenue, and thus the cash, if the futures contracts for Brent Crude oil amid the month of July average $15 higher and $15 lower than the cost at which one sold the swap (Hao, n.d.). It ought to be noticed that in light of the fact that the futures for Brent Crude oil expire almost two weeks prior to the production or delivery month, the prompt month contracts amid the month of July production are the August and September futures contracts. The August contract will be utilized to ascertain the settlement cost on July 1-16 where 16th July is found to be expiration date for the contract within August while the September contract will be utilized to compute the settlement price for July 17 to 31.
In the first situation, it should be expected that the average settlement price for the futures for prompt Brent crude oil, for every business day in July, is $78.00/BBL. For this situation, the price one attains at the wellhead for July production of July crude oil would be roughly $78.00/BBL. In any case, on the grounds that one supported with the $63 swap, one would acquire a loss related to hedging of $15/BBL which compares to net income of $63/BBL (Giandomenico, n.d.). In this situation, while one did experience a supporting loss of $15/BBL, the hedge performed as foreseen and permitted the producer to secure a price which was $3 per BBL more than the planned cost of $60 per BBL.
In the second situation, it is assumed that the settlement price on an average for the prompt Brent crude oil futures in accordance with every business day in July is found to be $48.00 per BBL. In accordance with the settlement price that is $48.00, one would attain $48.00 per BBL for the production of crude oil within July. Then again, because of the way that it was hedged with the swap of $63, one would acquire a supporting increase of $15 per BBL. Like the first case, the net revenue for this situation will be $63 per BBL and the hedging gain balances the lesser real price. By and by, the hedge did perform obviously and permitted to lock in the price worth $63 per BBL and either $3 per BBL more than the cost of $60 per BBL.
In accordance with this particular example, the gas and oil producers can moderate the exposure to the prices of crude oil being volatile costs while getting it hedged with swaps. In the event that the crude oil price amid these months averages not exactly the cost at which the swap was sold by the producer, the addition on the swap balances the abatement in revenue. Despite what might be expected, if the crude oil price amid the month averages above the price at which the the swap was sold by the producer; the loss on the swap is balanced by the revenue increase.
However, the above scenario addresses how the producers of gas and oil can utilize swaps to hedge the risk for oil price, a methodology quite similar to this can be utilized to hedge NGLs and natural gas as well. Also, marketers, consumers and refiners can likewise use the swaps for crude oil so that the cash flows can be hedged, inventories, costs, revenues and profit margins (Giandomenico, n.d.).
Another strategy could be to hedge with put option. In accordance with the commodity markets, an option is basically a contract which gives the contract purchaser the privilege, yet not the obligation, to buy or sell a particular volume of a particular commodity (for example, natural gas or crude oil) or the financial equivalence of the commodity mentioned, at the latest a particular date or time period.
There are two essential sorts of options, put options that are in considered as floors or call options that are referred as caps. A call option gives the purchaser of the option with a hedge against possibly rising costs and however, a put option gives the purchaser of the option with a support against conceivably declining costs.
Numerous producers for gas and oil hedge with put options as doing as such permits them to mitigate the exposure to reducing natural gas, NGL and crude oil prices. Essentially, numerous customers hedge with call options as call options permit them to minimize the effect of conceivably rising costs.
As a case of how the above example of selected commodity can hedge with put options, the producer of crude oil need to hedge the exposure to lower prices for crude oil to make sure that one can service the debt, as needed by the moneylender. All the more particularly, how about if it is assumed that one has to guarantee that one is hedged if there is trade by WTI underneath $50 per BBL. For the purpose of this illustration, how about if it is assumed that one is looking to hedge 5,000 BBLs of the production of crude oil by August 2015.
In order to fulfill this, one could purchase a $50 WTI within August a put option for crude oil. As this is being composed, a $50 August WTI average price for the cud oil(otherwise called an Asian or APO) put alternative is trading a premium of $2.95/BBL which implies that the cost for the hedging of 5,000 BBLs in accordance with this strategy would be $14750 i.e. 5,000 BBLs X $2.95/BBL.
Presently we should look at how the $50 WTI crude oil for August’s put option of crude oil will affect the business, and guarantee that one has the capacity to administer the debt, if the average of WTI crude oil futures prompt month amid August settles both above and underneath the strike price K being $50 per BBL. The prompt month futures contracts for WTI terminate before the month of production. On account of the August 2015 month of production, the brief month WTI contracts for future are the September and October contracts (Parkinson, 2013). The September contract will be utilized to ascertain the settlement cost from August 1-20 and (August 20 is the close date of the September futures contract for WTI) while the October contract will be utilized to compute the settlement cost for August 21-31.
In the first case, we should accept that normal settlement cost for the prompt futures for WTI crude oil, for every business day in August, is $70.00/BBL. For this situation, the actual price that one realizes ought to be roughly $70.00/BBL, barring basis, social transportation and gathering fees. On the other hand, on the grounds that one hedged with a $50.00 put option, the hedge would be “out-of-the-cash” and one would not acquire a gain or loss on the put option being $50.00 . As mentioned earlier, one needed to pay $2.95/BBL for the choice, so the real net, including the premium for option, would be $67.05/BBL (this does not involve gathering, basis emulated by the transportation expenses too). Plainly, this would be a decent surprise as $67.05/BBL would permit one for the servicing of debt as well as to generate an additionally productive profit also.
In the second case, one should expect that average settlement price for the prompt crude oil WTI futures, for every business day in August, is found to be $35.00 per BBL. In this situation, the real value that one understands at the wellhead ought to be near to $35.00 per BBL. Nonetheless, on the grounds that one supported with a put option of $50, the hedge would be in accordance with the money and one would not acquire a hedging gain of $15 per BBL. Moreover, one needed to pay $2.95 per BBL for the alternative, so the real net, including the option premium, would be $47.05 per BBL (once more, this avoids premise, transportation and gathering fees). While not almost as perfect as the first situation, a net of $47.05 per BBL would for sure permit one to guarantee that one can then service the debt, and ideally pay himself a bit as well (Parkinson, 2013).
The chart below demonstrates the potential results of the producer for crude oil hedging with a $50.00 WTI put option for a crude oil, as portrayed in the case. As the chart demonstrates, when NYMEX WTI unrefined petroleum costs normal $50/BBL or less, the net value including the alternative premium of $2.95/BBL, is 47.05/BBL. Alternately, when NYMEX WTI prices for crude oil normal more than $50 per BBL, the net cost is the NYMEX WTI month to month average minus the option premium of $2.95 per BBL.
As this example demonstrates, hedging in accordance with put option gives the producers of gas and oil gets the best of it as put option give a support against conceivably declining crude oil (and also natural gas fluids and natural gas as well) prices while permitting the maker to possibly benefit from higher prices additionally. So as to hedge effectively, the second venture must be in negative relationship to the original investment or trade. There are numerous approaches to hedge, however it essentially is making a bet, trade or investment trying to shield a financial investor from potential losses in another speculation. This implies that one speculation is creating returns that surpass those of the more extensive financial markets, and the other venture, which is the trade that is being placed to hedge; by and large it results in the generation of returns that are basically under the markets. On the other hand, practically speaking, there are only few commodity futures contracts really bring about delivery, most are used for hedging and are purchased or sold back preceding expiration. Then again, a futures contract gives the contract seller, the obligation and right, to sell the fundamental commodity at the cost at which he offers the futures contract. A futures contract gives the purchaser of the contract, the obligation and debt, to purchase the underlying commodity at the cost at which he purchases the futures contract.
References
Dash, M. and N.S., A. (n.d.). Exchange Rate Dynamics and Forex Hedging Strategies. SSRN Journal.
de Ville de Goyet, C. (n.d.). Comparing Conditional Hedging Strategies. SSRN Journal.
Fonseca, R. and Rustem, B. (2012). Robust hedging strategies. Computers & Operations Research, 39(11), pp.2528-2536.
Fonseca, R. and Rustem, B. (2012). Robust hedging strategies. Computers & Operations Research, 39(11), pp.2528-2536.
Giandomenico, R. (n.d.). Valuing an American Put Option. SSRN Journal.
Hao, T. (n.d.). Option Pricing and Hedging Bounds in Incomplete Markets. SSRN Journal.
Lautier, D. and Galli, A. (n.d.). Dynamic Hedging Strategies: An Application to the Crude Oil Market.SSRN Journal.
Loss, F. (2012). Optimal Hedging Strategies and Interactions between Firms. Journal of Economics & Management Strategy, 21(1), pp.79-129.
Parkinson, M. (1977). Option Pricing: The American Put. J BUS, 50(1), p.21.
Yun, W. and Jae Kim, H. (2010). Hedging strategy for crude oil trading and the factors influencing hedging effectiveness. Energy Policy, 38(5), pp.2404-2408.
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