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Detailed Glossary
Detailed Glossary
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Invoicing | ||
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Like most businesses, we sell something, we deliver it, we raise an invoice, we send it to our buyer, we get paid - we hope. The Master Agreement between us and our counterparty will specify if we raise an invoice for a specific delivery (of oil for example), or for a continuously delivered commodity (gas or power for example) over a period (usually a day, week or month) Detail The two main invoicing schedules are:
Invoices usually have the following granularity:
We may therefore raise a number of invoices for a counterparty, with different combinations of the above Once we generate, or raise, an invoice, and are satisfied that it is correct, we transmit the invoice(s) to our counterparty, and we post the invoice(s) into an Account in our General Ledger We expect our counterparty to be doing the same for commodities that we have bought from them, and expect to receive invoice(s) that we will check against our own records To help this we raise a set of shadow invoices, or purchase orders, so that we can compare these to the invoices received from our counterparty. Once agreed we post these purchase orders into an Account in our General Ledger | ||
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... | ||
Take or Pay | ||
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A type of supply contract in which the buyer commits to buying a minimum quantity of some product, or to make an alternative payment for the amount below the minimum quantity Take or Pay contracts are widely used in the Gas and Oil markets Detail The minimum quantity, the price of purchase, and the price paid for any amount below the minimum are all defined in the contract Typically the buyer nominates a delivery volume each day from the supplier, the minimum quantity applies over a year | ||
Virtual | ||
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Something that behaves like something else but is not really that thing Detail We've all heard of virtual reality - it appears (or tries to appear) real but is not, but it does have many of the characteristics of real So what does that mean for us? Well let's take a real(!) example Virtual Storage - Storage allows organizations to inject gas at one point in time and withdraw it later An organization (the seller) may sell another organization (the buyer) virtual storage the buyer of the product sells gas at no cost to the seller at some point later in time the buyer of the product requests the seller of the product to sell the gas back at no cost the seller tracks the level of virtual gas, and tracks this against the virtual capacity of the storage product sold | ||
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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Netting | ||
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Netting is the aggregating and offsetting of multiple cash flows between counterparties to arrive at one, or a limited set of physical payments Detail There are two distinct sorts of netting: Settlement Netting - which might also be described as payment netting All cash flows between two parties are summed (receipts are positive, debits negative) to arrive at one physical payment due Settlement Netting granularity aggregates cash flows to a single legal entity over one or more cash flow attributes including:
The exact terms of Settlement Netting are described in the bilateral Master Agreement that we have in place with the counterparty Close-out netting - The set of outstanding cash flows that will be netted if our counterparty goes into receivership or liquidation If we are expecting a payment of £999,999 from our counterparty, and they are expecting £1,000,000 from us, and they go into liquidation - we want to be owing them £1, not £1,000,000. The liquidator will do his best for all creditors to try and get us to pay the £1,000,000, and have us wait in line with other creditors for the £999,999. Indeed without a legally sound close out netting agreement in place the liquidator would be favouring us as a creditor were they to let us net the outstanding payments | ||
Nomination | ||
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An electronic message sent to a third party detailing a transaction or requirement as part of a pre-existing agreement Typically gas and power transactions are nominated to system and market operators Detail Examples of nominations:
Nominations are sent typically some time in advance, and then updated as any changes occur (new trades are executed, new forecasts are made etc.) For power and gas there are deadlines for the last nominations for a delivery period - if nominations are missed then the trading organization may face large imbalance costs so: Nominations are one of the most time-critical processes or capabilities of any trading organization In the UK nominations are officially known as Notifications - but the general term, nomination, is more usually used | ||
Option | ||
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At its simplest an energy option is an instrument that gives the buyer the right, but not the obligation, to buy, or to sell, a commodity at a specified price at some point in the future.
More complex options may be financially settled, the payout being dependent on some condition(s) being met, and varying with some observable value(s) at the time of exercise
There is usually a single non-refundable payment made by the buyer of the option (the holder) to the seller of the option (the writer) - this is the option premium
Detail
First, let's try and categorize the different types of options we'll come across, and then describe each in detail, starting with the simplest:
1. Vanilla options - so called because they are a standard "flavour", which may themselves be divided into:
a) Simple physical options - already briefly described above, these include European and American options
b) Financially settled options - these pay out if some measurable, usually a published index, meets some specified criteria. The payout varies with this or other measurables. This category includes Asian options
c) Simple combination options - not strictly different types of options, but traders frequently combine simple options to tailor risk and payout to their circumstances
2. Exotic options - in contrast to vanilla options, exotic options are non-standard, usually complex and are designed to offer, or conceal, a combination of characteristics
Let's look at the simpler types in more detail
Simple physical options
Simple physical options may be thought of as an option to execute a Forward Contract. Indeed, if the option is exercised it effectively becomes a Forward Contract
When the option is traded the following terms are agreed:
Financial options Financial options pay out a cash amount if they are in the money - the cash payout usually being the difference between a fixed strike price, and some variable observable, usually the published price of a energy commodity or product Spread options and options on swaps (swaptions) are types of financial options Asian options are financial options which pay out on the average price of an underlier over the delivery period - assuming they are in the money | ||
OTC | ||
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OTC - Over-The-Counter Generally used to refer to any trade not executed with an Exchange Detail Over-The-Counter trades may be executed by a broker, or directly bilaterally between two parties. The resultant trade, whether brokered or not has the following characteristics: The trade details may be anything the parties agree - compared to the standardized contracts offered on an Exchange The agreed trade price is private to the parties - although either may report it to a market data service to increase price transparency Delivery, settlement, and all credit risk is entirely between the two parties | ||
P&L | ||
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Profit and Loss (P&L) is a finance and risk reporting term to describe the profitability of an individual trade, a book, a desk, or a company. Whilst the P&L of a company includes all activity, and costs (offices, staff etc.) the trading P&L is a measure of the profitability of a single, or a set of, trade(s) Detail P&L is a change in the value of something, or a set of things between two points in time You will often hear people refer to the P&L of the trade in terms of its value - the value at any point in time is effectively the difference between the value at that point in time, and the value before the trade was executed. We usually refer to this as the Lifetime to Date P&L or LTD P&L Often we are interested in the change in value, the P&L, from the start of the year, from the start of the month, or from the last valuation. These are respectively known as:
As an example, let's say we bought some shares in a company for £60, and a year later we sold them for £100, then it seems obvious that we made £40 profit, assuming there were no cost of buying the shares, or selling them, nor indeed any other costs directly associated with the buying or selling
Before continuing we will align our example with a more normal energy trading example.
In general traders don't buy a commodity, and then sell it later because of the difficulty and cost of storing energy commodities - see Storage
In general traders enter into a Forward contract, that is to buy the shares at fixed time in the future, at a fixed price
The other advantage of Forward contracts is that the trader can enter a Forward contract to sell, as well as buy, at some time in the future. This is known as taking a short - i.e. negative - position
In March 2018 we will give £60 to the seller of the shares. This is called the financial side or leg of the trade. It has a known cash value: £60
We call this the physical side or leg (it's physical because it's not cash, even though the share certificates are electronic, we still call this physical)
In general the first method is preferred because it is simpler, we may have to use the second method when we are not sure the position is entirely closed out, or we know some is, and some isn't.
if the first method sounds odd, think about buying and selling a house, once you've bought a house you're very interested in how much you paid for it, and how much it's currently worth. Once you sell it however, you're only really interested in the price you paid and the price you sold it. You have little real interest in the current price
P&L that may result in a cash flow in the future is often discounted back to present day value
We may refer to undiscounted, and discounted P&L
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