chapter 4

Forward contract:

• Agreement today to buy or sell a commodity at a predetermined price at a predetermined time in the future.

• It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today.

• A forward contract is traded in the over-the-counter market.

• One of the parties to a forward contract assumes a long position and agrees to buy the

underlying asset on a certain specified future date for a certain specified price.

• The other party assumes a short position and agrees to sell the asset on the same date for the same price.

• Commodity swaps are in essence a series of forward contracts on a commodity with different maturity dates and the same delivery prices.

• A swap is an over-the-counter agreement between two companies to exchange cash flows in the future.

• The agreement defines the dates when the cash flows are to be paid and the way in which they are to be calculated.

• Usually the calculation of the cash flows involves the future value of an interest rate, an exchange rate, or other market variable.

• A forward contract can be viewed as a simple example of a swap.

• Whereas a forward contract is equivalent to the exchange of cash flows on just one

future date, swaps typically lead to cash flow exchanges on several future dates.

Hull, 2012, p.148 Levent Yilmaz, Konstantin Lenz, Thomas Siegl 74

4.2 Commodity Swaps

• Swap Transaction: Agreement today to buy/sell commodity at a predetermined fixed price over a predetermined period of time. (often financial)

• A commodity swap is a type of swap agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period.

• A commodity swap is similar to a Fixed-Floating Interest rate swap.

• A commodity swap is usually used to hedge against the price of a commodity

• Swaps are arguably the most popular - because swaps can be customized while futures contracts cannot - hedging instrument used by oil and gas producers to hedge their exposure to volatile oil and gas prices as hedging with swaps allows them to lock in or fix the price they receive for their oil and gas production.

– forwardcontracttradedonanexchange

– standardizedregardingtradedmaturities,quantityofthecommodity – standardizedmethodofdeliveryofthecommodity

• giving rise to physical delivery by the seller at maturity

• or financial settlement: needs a liquid reliable index to represent the underlying at maturity – standardizeddeliveryperiod:

• Delivery may take place once on a specific day (e.g. Emissions, Metals) or

• continuously over a specific time (e.g. power or gas: Day, Week, Month, Quarter, Year)

• corresponding to the continuous delivery in financial settlement is an index averaged over the time period: (e.g. freight, coal, financially settled power).

• Longer term products (like quarter or year) are split to shorter periods (month) either at time of trade (strip clearing: CME/ICE) or at time of delivery (cascading: ECC)

• Like a forward, and unlike an option, a Futures contains an obligation to buy or sell.

• The counterparty is the Clearing House of the Exchange, the lines of defense of the CCP apply.

What is synthetic storage and synthetic transport?

1. Hedging: Hedging is a strategy to protect against potential losses by taking an opposing position to a risk. It aims to minimize the impact of adverse price movements on an investment.

2. Speculation: Speculation involves taking positions in financial markets to profit from short-term price fluctuations. Speculators aim to predict and take advantage of market movements to generate profits.

3. Arbitrage: Arbitrage is a strategy to profit from price differences in different markets or financial instruments. It involves simultaneously buying and selling related assets to exploit temporary price discrepancies and generate risk-free profits.

In essence, hedging mitigates risk, speculation seeks profit from market movements, and arbitrage exploits temporary price differences for guaranteed profits.

Open interest (OI) is the total number of outstanding futures contracts that are not closed or delivered on a particular day. Trade Volume is the number of traded contracts.