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Nick Henfrey |
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Linear trade | ||
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A trade with no optionality Detail Why? The linearity refers to the delta - that is the variation of the value of the trade with the main underlier Trades with no optionality have a value that is directly proportional to the value of the underlier - if we plot the value against the value of the underlier it will be a straight line - hence linear trade Trades with optionality do not have a linear relationship between value and underlier. As the value of the underlier becomes less and less favourable the value of the trade becomes nearer and nearer to zero Unsurprisingly these trades are known as non-linear | ||
LNG | ||
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Liquefied Natural Gas Natural Gas is difficult to liquefy by compression alone, it is usually liquefied, stored and transported at very low temperature LNG acts like oil and coal for transportation, like natural gas once it is returned to its gaseous form Detail Unlike propane gas it is not practical to liquefy natural gas (which is mostly methane gas) by compression alone, and it is normally liquefied by refrigeration to -160 oC and stored and transported at moderate pressures LNG needs to be transported in specialist ships (LNG vessels) that can maintain the low temperature required, so are quite different to other commodity carriers On arrival at a destination port the LNG needs to be returned to its gaseous state in a plant which is attached to a gas terminal Other than the ships themselves the logistics of LNG transport involve the same complexities as oil and coal LNG is big business for two main reasons: A vast quantity of natural gas is already available from oil rich countries - but there are no pipelines to flow it long distances (Russian gas into Europe being the main exception) The process of extracting natural gas from unconventional sources (typically shale) by hydraulic fracturing ("fracking") is likely to yield even more gas - but usually not where it's needed
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Location | ||
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Location is one of the key dimensional attributes of all physically settled, and many financially settled, trades Detail Location is usually a description of where the delivery a of a trade will take place Although this sounds fairly straightforward, in practice location means different things for different commodities. This is because the delivery location simply defines the lowest level of distinguishable information about the delivery, and this lowest level varies with the commodity So let's look at some commodity locations to see what this means: Natural Gas The location of the majority of gas trades in the UK is the NBP The NBP isn't even a real location, it describes the UK-wide gas pipeline network called the National Balancing Point On the day of delivery, a seller of gas has an obligation to deliver gas at the NBP The seller may deliver it from any other location that is physically connected to the NBP, it doesn't matter where that is. The buyer may take delivery to any other location that is physically connected to the NBP Gas traded locations such as the NBP are called hubs. Some hubs require the buyer and seller to identify the physical connection point of delivery - these are physical hubs Other hubs, like the NBP do not require the buyer and seller to identify the connection point - these are virtual hubs | ||
Margining | ||
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Margining is a form of Settlement, whereby exposure to Credit Risk between two parties is limited by keeping the overall Credit Exposure below a certain threshold by means of Margin payments between the parties whenever the threshold is breached Detail Let's take a simple example
If you go out of business or default on the deal I won't lose out
But if I default then you will lose $200
I need to arrange for that $200 available to you in case I do default
On day three we both note that the price has risen to $62 per tonne - that's good for me, bad for you Now if I default you won't need to deliver $12,400 worth of coal in exchange for $12,000 cash
But if you default then I'll be $400 worse off
You need to arrange for $400 to be available to me in case of default
Let's say on day eight the price rises to $66 per tonne
You now need to arrange for $1,200 to be available to me in case of default
We talked about making the cash available in case of default - how does that work?
There are actually a few different schemes:
Clearingin a clearing arrangement each if us has a margining account with a central clearing house
Before we even start trading we need to deposit some money into the account, and each time we execute a trade we need to make sure there is sufficient in the account to cover a certain amount of loss
Let's say we both deposit $1,500 initially and then an additional $1,000 as a result of doing the single trade - we can see that on typical price movement, for the volume of the trade this, then it would take quite a large movement in the price to change the value of the trade by $1,000
We both now have $2,500 deposited
The initial $1,000 deposit against this specific trade is called the Initial Margin
At the end of day two the clearing house would remove $200 from my account and put it into your account - this is the Daily Variation Margin
I now have $2,300 and you have $2,700
At the end of day three the clearing house would remove $600 from your account and put it into my account - this is the Variation Margin
I now have $2,900 and you have $2,100
At the end of day eight I would have $3,700 and you have $1,300
At this stage you would need to make a payment into your account to top it back up to a minimum level - this may be $200, or it might be more depending on the agreement
CollateralWe might agree to post $2,000 collateral with each other to cover any initial movement either way
We agree to margin limits of a minimum of $1,500 and a maximum of $2,500, if the margin falls below $1,500 we will post a minimum of $500 to get the collateral back up to $1,500, and likewise, if the collateral goes above $2,500 we will be able to withdraw cash to bring it below $2,500
At the end of day two my collateral stands at $1,800 - the cash in the collateral account minus the $200 current liability on the deal at that point - we're both OK, I have more than the minimum $1,500
At the end of day three I have $2,400 collateral and you have $1,600 (your original $2,000 less your current liability of $400 on the deal)
At the end of day eight I have $3,200 collateral, and you have just $800 (your original $2,000 less your current liability of $1,200 on the deal)
A requirement to top up a clearing account or collateral account is known as a margin call
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Mark to Market | ||
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A way of valuing the unrealized P&L of a simple linear Forward, Futures contract or Swap Detail Most businesses that own assets or hold inventory routinely value those assets and inventory, the change in value between two points in time is the profit or loss Some assets, like computers, simply depreciate, and a simple depreciation percentage is used each year Other assets, like buildings, vary in value with the market conditions, and are generally valued using a mark to market principle (that is we simply look and see what the building is worth at the end of the accounting period) It's important to realize that each trade is an asset (or a liability) - it's a firm contract and must be valued like any other asset The current value of a single trade is the difference between the price paid, and the value of the delivered commodity when it is delivered (which may be a cargo, a day of gas delivery, or a half hour of power delivery) We can find the value of the commodity once it has delivered by looking up the spot trading price on the day of delivery But to value the deal before delivery we must mark the value of the delivered commodity to the market; that is we set the value of the commodity to the price that is currently being paid for the delivery period For example: We have bought 10,000 therms of gas for delivery in March next year at 25p per therm Each day we can look at the average traded price for that month, and mark the value of the 10,000 therms to that price After two days we note that March is trading at 27p a therm, so we mark the physical value to the market price of 27p, and subtract the price we will pay, 25p. The unrealized P&L is therefore £200 ((27p - 25p) * 10,000). Each day we will need to repeat this calculation until the delivery is complete | ||
Market | ||
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In Energy Trading a Market describes a standardized trading environment for a commodity and a geographic zone The geographic zone is not necessarily the delivery location, but usually determines the valuation of the traded commodity For example API#2 is a market based on the published index for coal in the Amsterdam, Rotterdam and Antwerp (ARA) location; a trade may deliver coal to a port in France but still be part of the API#2 market Detail A market combines attributes of commodity and location and may have an associated calendar and business rules, which provide defaults for any trade associated with the market Some delivery locations are also markets, so far example NBP is a gas location and also market Note the similarity and difference to a Master Agreement which has similar attributes | ||
Market Maker | ||
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A market maker quotes prices at which they are prepared to buy or sell a commodity - usually on an Exchange or with a broker Detail A price at which a party is prepared to buy is called a Bid (they bid to buy the commodity) A price at which a party is prepared to sell is called an Offer (they offer to sell the commodity) By offering continuous bid and offer prices, Exchanges encourage traders to take positions, secure in the knowledge that they can always close them out. This is another way of saying that they improve the liquidity of the market There are usually benefits to the market makers themselves from offering this service | ||
Master Agreement | ||
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When two parties execute a trade between themselves they specify the terms of the trade: Price, Volume, Location, timing etc. But in order to successfully manage the trade's delivery and settlement a lot more information needs to be available than is captured in the trade details, such as when payment is due, who needs to notify a TSO etc. This additional detail is held in a Master Agreement Each trade that is executed is regulated by a Master Agreement Detail Master Agreements exist to cover various sorts of trade, for example the UK standard gas and power Master Agreements : GTMA (Grid Trading Master Agreement) covers UK power trading, complete with all the details of notification NBP97 (Short Term Flat NBP Trading Terms and Conditions Ref. NBP 1997) covers natural gas trading at the NBP complete with details of nomination Master Agreements may reference other Master Agreements - ISDA for example is an organization that is aiming to offer master agreements that unify trading, for example at the NBP and at TTF Master Agreements are themselves referenced by bilateral trading agreements, which are agreements set up by pairs of potential trading partners to specify which Master Agreements will be used for different products and instruments, and usually cover other arrangements such as netting, collateral etc. Master Agreements may have schedules or annexes that define additional terms, or override terms in the main agreement Bilateral Master Agreements may have additional schedules that define variations to the standardized master agreements A Confirmation, as well as confirming the trade details, also confirms the master agreements that regulate the trade, and may itself contain exceptions or variations from the general bilateral terms
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Maturity | ||
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Generally a financial trading term used sometimes in the commodities trading market to mean the expiry or expiration date - particularly futures contracts Detail A classic energy futures contract has a single date that represents: The last date it may be traded The date it is cascaded to shorter contracts The date it is completely settled (if a financial futures contract) This date is usually called the expiry date, and therefore it is also the maturity date However it is possible that the contract may continue to be financially settled after the last date it may be traded - in this case the maturity date is usually the completion of financial settlement Be careful when looking at contract details - the terms are used inconsistently between exchanges and brokers... | ||
Megawatt | ||
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A Megawatt is a measure of energy per unit time
Abbreviation is MW Not to be confused with MWh Detail In energy trading we usually refer to electricity as power In physics power is energy per unit time
Gas and power trades are often specified in Megawatts because they have a continuous flow rate However energy trades are priced in terms of energy (e.g. €45.3/MWh) so we need to be able to calculate the number of MWh of the trade or delivery period This is easy if we use the equation: 1 MWh = 1 MW flowing for one hour and simply remember this Megawatt.hours = Megawatts x hours or MWh = MW x hours Just like the speed of a car: you can't meaningfully add two values in Megawatts at different times - what does it mean to add two speeds together at different points on the Motorway? If I drive 60 mph for 10 minutes, then 72 mph for the next 5 minutes, does the number 132 mph mean anything? (No!) If I flow 10 MW one day and 20 MW the next day, the value 30 MW has no meaning you can meaningfully add two values in Megawatt hours at different times If I drive 10 miles in the first ten minutes, then 6 miles in the next five minutes, then I have driven 16 miles in total If I flow 240 MWh one day and 480 MWh the next day, then I have flowed 720 MWh over the two days you can't normally price something in Megawatts - a toll road makes you pay per mile, it doesn't matter how fast you went For clarity: 1 Watt = 1 joule per second; 1 W = 1 j/s 1 kilowatt = 1,000 Watts; 1 kW = 1,000 W 1 Megawatt = 1,000 kilowatts; 1 MW = 1,000 kW 1 Gigawatt = 1,000 Megawatts; 1 GW = 1,000 MW 1 Terawatt = 1,000 Gigawatts; 1 TW = 1,000 GW | ||