Dark Energy Consulting
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Detailed Glossary
Detailed Glossary
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Swap | ||
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An Energy Swap is generally a swap of two different prices on an identical, or similar, Energy underlier Detail While financial market swaps may involve swapping almost any cash flow for any other cash flow, an Energy Swap involves the swap of two different prices on an identical, or similar energy product or underlier. The two types of Energy Swap are:
By definition, Energy Swaps are always financially settled Energy swaps may be traded OTC or on an Exchange An Energy Swap is very similar to a a financially settled Futures or Forward Contract Exchange traded swaps are generally settled through non-daily margining - and therefore have credit risk Financially settled futures, like all futures, are settled through daily margining - and have minimal credit risk | ||
Basket | ||
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Forward | ||
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A Forward, or Forward Contract, is an agreement to buy or sell a commodity at a fixed time in the future Details A Forward Contract involves two trading parties: a buyer and a seller. Our organization is one party, the other is the counterparty A Forward Contract can involve almost any terms for quantity (Volume), quality, commodity, delivery period, delivery location, pricing and settlement A Forward Contract may be executed directly with a counterparty, or through an intermediary (a broker) Whether brokered or not, responsibility for delivery and settlement of a Forward Contract is usually directly with the counterparty (see Clearing for an exception) Forward Contracts may be executed at a fixed price, or at a floating price:
Forward contracts may be physically or financially settled:
A financially settled Forward is often referred to as a swap A Forward is usually settled bilaterally between parties. Forwards may be included in a netting agreement Forwards may be included in a margining agreement A Forward may be given up for clearing
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Clearing | ||
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A form of settlement where responsibility for payment is passed to a third party: a Clearing House or Clearing Broker The Clearing House accepts responsibility for settling the deal. Credit risk for the seller in the trade is reduced to almost zero The Clearing House minimizes its Credit Risk by daily margining Detail An organization may trade on an Exchange either by becoming a member of the Exchange, or trading through an Exchange Broker. The clearing principles are similar in either case In general a trading organization engages a Clearing Broker to act on its behalf The trading organization is required to open a margin account with the Clearing Broker, which in turn maintains a margin account with the Exchange's Clearing Bank As the organization enters into a trading position the Exchange marks the trades to market on a daily basis, and transfers cash into or out of margin accounts based on the change of the value of the trading position since the previous day. The Clearing Broker mirrors this operation to its clients' margin accounts Every trading organization is required to maintain an amount of cash in the margin account to cover a substantial short term loss in the value of its position. If the trading organization does not maintain this margin then the Exchange closes out the position immediately, using the margin account cash to cover any losses as a result of the close out Payments into the margin account as a result of new trades that cause an increased open position are called Initial Margin payments Payments into the margin account as a result of the value of trades falling are called Variation Margin payments | ||
Settlement | ||
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The Business Process or Capability covering the payments relating to trading activities. It includes agreeing payments, making them, and ensuring that payments are received at the correct times Detail Settlement includes: We also referred to the concept of financial and physical settlement of trades
We need to be careful to recognize the legal definition of settlement of a physical trade:
Most other parts of energy trading businesses identify the term settlement with cash settlement (or payment) | ||
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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Futures Contract | ||
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A Futures Contract is an agreement to buy or sell a commodity at a fixed time in the future executed on or with an Exchange Detail Note the similarity in description to a Forward Contract We will focus mainly on the differences Exchanges list standardized products that may be traded. A product describes a standardized commodity, delivery period and delivery location that may be traded Exchanges list a buy and a sell price for every different product they list. These buy and sell prices are provided by Market Makers Futures Contracts are always cleared Futures Contracts may be physically or financially settled A financially settled futures contract may be taken into the delivery period, and is settled by daily margining at the daily fixed in price If you're wondering how that is different to an exchange-traded swap - then the difference is a swap is very like a financially settled futures contract, but the swap is generally not daily margined | ||
Spread | ||
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A spread is a difference in price, or value, of two similar but different underliers An Energy Spread trade s a type of trade between two floating prices on similar but not identical energy underliers Detail Spread trades are usually financially settled Different types of Energy Spread are classified by the difference in the underliers:
Many commodity spreads are associated with the cost of generating electricity, so they involve electricity as one commodity, the others may be:
Another group of commodity spreads are associated with the cost of refining, so they involve crude oil as one commodity, the others being refined products such as gasoline. These are known as crack spreads Spread is also used to describe the difference in prices between locations, times, commodities
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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 | ||
Execution | ||
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