Chapter 8: Futures and Forwards

8.1 Introduction

Futures and forwards in the energy market historically have been used for physical delivery by entities directly involved in the use of energy. The buyer of the physical contract provides a payment as defined by the fixed contract price and the seller delivers the commodity to a predetermined location at conclusion of the contract. Over time, a significant share of the products was traded by companies that were merely involved in the distribution of energy. Currently, a major fraction of the trading volume for energy products is by financial firms with no direct link to the actual production, consumption, or even transfer of energy. Understandably, cash-only financial contracts are now widely available to meet the demands of profit-seeking market participants.

8.2 Fair Value

At the time of a cash-only settlement, the seller of the forward is contracted to deliver the time monetary value of the commodity in lieu of the actual commodity. The buyer is contracted to deliver the originally negotiated forward price . In practice, there is positive cash flow to the seller if and positive cash flow to the buyer if .

The forward price curve ...

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