Energy Trading and Risk Management: A Practical Approach to Hedging, Trading and Portfolio Diversification

CHAPTER 3 Plain Vanilla Energy Derivatives

The term derivative has been tossed around quite a bit recently. If we’ve made any progress during the ongoing, seemingly endless financial crisis, it’s that people now recognize the word derivatives. So what are derivatives? Why are they important in the energy markets?

In Chapters 3 and 4, we define, illustrate, and discuss various types of energy derivatives—plain vanilla and exotics. Then in subsequent chapters we examine the primary applications of these energy derivatives to

• Hedge or manage price risk
• Speculate or “gamble”

Energy generators wish to hedge their output to protect themselves against falling prices. End users wish to hedge against price increases for purchases of energy products. Financial institutions are essentially uninvolved in the physical energy markets. However, many large banks are active in the over-the-counter (OTC) and exchange-traded derivatives markets.

3.1 DEFINITION OF ENERGY DERIVATIVES

What are energy derivatives? Let’s take a look at three different definitions. The first two definitions are more technical in nature. The third definition is from a regulator’s perspective.

1. Investor Words defines an energy derivative as a derivative whose underlying asset is some type of energy product, such as oil, natural gas, or electricity. Energy derivatives may be options, futures, or swap agreements. They ...