Introduction to Derivatives

Futures and Options

What is a financial derivative? In the business world, the term is bandied about daily and is or is not defined as "a financial instrument that derives its value from some other instrument or index." This description is rarely enlightening and does not adequately explain its meaning. Further, a generally agreed upon or authoritative definition of a derivative instrument does not exist. Recent documents by the Financial Accounting Standards Board (FASB) describe derivatives as "forwards, futures, swaps, options, or financial instruments with similar characteristics." Still, what does this mean?

Financial derivatives are contracts between two parties under which they agree to an exchange. Often the exchange involves cash flows or another financial instrument, the value of which may vary during the term of the contract. Forwards, futures, swaps, and options are just common examples of derivatives.

This case, however, deals with instruments often described as commodity derivatives. These instruments are not purely financial but involve the exchange of cash for a commodity such as energy, precious metals, and agricultural products. The case focuses on futures contracts or options on futures as a means of managing risk. Attaching option packages such as caps, floors, and collars to the contract provides the user with a more complete solution to risk management within a single transaction.

Terminology specific to commodities

1. Futures - A firm agreement to deliver a certain volume of a commodity at a specified date or dates in the future and which can be bought and sold exclusively on a regulated exchange. Futures contracts are settled daily based on their current value in the marketplace.
2. Options - A contract that provides the buyer of the contract the firm ability to buy (or sell) a commodity from the option writer (seller) at some time in the future at a predetermined price, but without obligating the buyer to execute the purchase (or sale).
3. Option on Futures - An option structured so that the buyer receives a futures contract guaranteeing delivery at the option strike price. The options are American options and can be exercised on any business day prior to its expiration.
4. Option Premium - A fee that is paid by the buyer to the option writer for this flexibility. This is generally paid up front when the option contract is originally written.
5. Strike Price - The contract price at which the option buyer has the right to buy or sell the commodity. Also called the exercise price.

Types of Contracts

There is regulated exchange trading in two types of options on futures contracts, known as call options and put options. Deciding on which one to consider investing in depends entirely on the investor's price expectations. That is, it depends on whether the investor predicts the price of a particular commodity to rise or fall.

• Call Option on Futures: Purchasing a call gives you a specific locked-in price at which you have the right, but not the obligation, to buy a futures contract on a commodity that you expect to increase in value. As a result, if you look for the price of natural gas to increase, you would buy a natural gas call option.
• Put Option on Futures: Purchasing a put gives you a specific locked-in price at which you have the right, but not the obligation, to sell a futures contract on a commodity that you expect to decrease in value. Consequently, if you look for the price of natural gas to decrease, you would buy a natural gas put option.

Option Payouts

Asymmetrical Risks: Option payouts are different from swaps and futures because they have asymmetrical risks. Risks are limited on one side and unlimited on the other.

1. Buying (Long) a Call: A call buyer profits when prices rise above the strike price. Below the strike price, the call does not have exercise value, but the buyer has a sunk cost in the premium paid up front. (see graph)
2. Writing (Short) a Call: A call writer earns and keeps the premium when prices are below the strike price. But as prices rise above the strike price, the writer begins to pay out. At some point, the payout exceeds the premium earnings (breakeven) and subsequent price increases add to net losses. (see graph)
3. Buying (Long) a Put: A put buyer profits when prices fall with respect to the strike price. Above the strike price, the put has no exercise value, but the buyer has a sunk cost in the premium paid up front. (see graph)
4. Writing (Short) a Put: A put writer earns and keeps the premium when prices are above the strike price. But as prices fall below the strike price, the writer begins to pay out. At some point, the payout exceeds the premium earnings (breakeven) and subsequent price declines add to net losses. (see graph)

There is no upper limit on the opportunity for profit. The greater the price movement, the larger the profit (provided that it moves in the direction you anticipated and that it occurs during the life of the option). As previously mentioned, it is the combination of limited risk and an unlimited opportunity for profit that makes these options attractive as an investment vehicle.

Option Packages

Option dealers will combine multiple options into user-friendly package transactions that provide option users a more complete solution in a single transaction. The most common option packages are caps, floors, and collars.

1. Caps - A series of consecutive monthly calls provides continuous protection to a consumer of energy. A package of such a series of calls into a single transaction is called a cap. Each month market prices for the current month are measured against the cap strike price. If prices are higher than the strike price, the cap buyer is paid the difference. If prices are lower, there is no payment. This exercise is repeated each month. The cap buyer pays for the cap with an up-front premium payment.
2. Floors - A series of consecutive monthly puts provides continuous protection to a seller of energy. A package of such a series of puts into a single transaction is called a floor. Each month market prices for the current month are measured against the floor strike price. If prices are lower than the strike price, the floor buyer is paid the difference. If prices are higher, there is no payment. This exercise is repeated each month. The floor buyer pays for the floor with an up-front premium payment.
3. Collars - An option package consisting of a series of purchased calls and sold puts creates a collar and provides price protection against rising prices to an energy user. The short puts in series require payout if prices fall. For an energy user, this payout is offset by lower energy costs. The net effect is a minimum cost of energy and, from the calls, a maximum cost for energy.

Option packages share certain common structural characteristics:

• Independent Exercise - Each monthly call or put in the option package is exercisable independent of actions taken with other options in the package. Exercising one option does not affect the ability to exercise other options in the package.
• Single Transaction - An option package, although effectively containing multiple options, is documented as a single transaction.
• Financial Settlement - As a general rule, option packages do not require physical delivery at settlement. Settlement is generally cash settlements.
• Single Strike Price - In many option packages, a single strike price is established and applied to all the component options.

Concept of Hedging

A hedge is a mechanism by which a party minimizes its exposure to price volatility. The function of a hedge is to preserve the value of a product held by a party or to lock in a profit on a future sale or use of the product by the party. In other words, a party has a position in relation to the product and they want to protect that position. A party will either be long or short in a position.

• A long position means that a party has purchased or holds the commodity and has the need to protect the value of the commodity held or purchased.
• A short position means that a party has sold, or does not have the commodity, and has the need to protect the value of the sale made.

An ideal or perfect hedge leaves no remaining price risk. The hedge has covered the entire risk identified and the value is locked in or guaranteed.

Hedging requires the assessment of the cost and advisability of a perfect hedge versus a partial hedge. A partial hedge mitigates some, but not all of the risk.

A variety of factors are involved in this assessment of cost and advisability. The cost of a hedge depends upon the:

1. term of transaction - the longer the term, the more expensive
2. complexity of deal - the more complex, the more expensive
3. location of purchase (sale) - the longer the distance the commodity has to travel, the more expensive, and
4. liquidity of the players - the less liquid, the more expensive.

The advisability of the hedge depends upon the risk appetite of the participants and the results of the cost/benefit analysis performed.

Strike Price

Corporate treasurers can choose a variety of strike prices for hedging purposes: in-the-money, out-of-the-money, and at-the-money options. In-the-money call (put) options have exercise prices lower (higher) than the market price of the optioned asset. Out-of-the-money call (put) options have strike prices above (below) the asset's market price. At-the-money options have strike prices equal to the market price of the asset on which the option is written.

While out-of-the-money options are cheaper, they also offer less protection to the treasurer. Since it is the protection of the underlying cash flow that is the major reason for hedging, treasurers are likely to reject options that are way out of the money for hedging purposes. In-the-money options are more expensive than at-the-money options. Therefore, treasurers are likely to prefer at-the-money options since they tie up less of the corporate funds over the life of the option.

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