Derivatives And Oil Price Risk Assignment Sample

Derivatives products for hedging oil price risk

Date: January 29, 2024

Selected Exchange: NYMEX (New York Mercantile Exchange)

Methodology for Identifying Most Actively Traded Derivatives: The derivatives were selected based on their daily trading volume and relevance to the oil market.

WTI Crude Oil Futures (Ticker Symbol: CL)

The WTI Crude Oil Futures are one of the primary financial instruments used for oil price risks trading and hedging (Yu et al., 2023). Traded on the NYMEX, these futures contracts provide traders with an opportunity to speculate or hedge against fluctuations of oil prices (Chen et al., 2021). The delivery mechanism is in units of 1,00 barrels per contract and trading takes place from Sunday to Friday with a one-hour break each day. The millions of contracts that are traded every day prove the high liquidity and importance in the oil market (Nekhili, Mensi and Vo, 2021). WTI futures have different influences such as shifts in seasonal demand, and political affairs across the world business operating environment (Bashir et al., 2022). It should also be mentioned that the margins and collateral conditions for these futures may differ, so it is recommended to check with the exchange directly.

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Brent Crude Oil Futures

Brent Crude Oil Futures work in the same way with WTI Futures but they are backed by another key international oil marker – Brent crude (Wei, Zhang and Wang, 2022). Such futures are vital for hedging oil price risks, especially in markets that depend on Brent crude. Brent futures contracts are also liquid, with monthly expirations and trading on major exchanges like WTI. Many factors, such as geopolitical events and changes in world oil supply-demand balances influence Brent futures pricing (Zhang, 2022). Individuals who would like to trade Brent futures should visit the relevant exchange for more information on the specifications of that particular contract, such as size, trading hours and margin.

Options on Crude Oil Futures

Crude oil futures options give traders the right to buy or sell a futures contract, but not an obligation (Schofield, 2021). Both futures of WTI and Brent have these options available; they provide a means to hedge or trade on oil price volatility more independently as opposed from trading actual contracts. The option trading gives opportunities to apply different strike prices and expiration dates that make it suitable for various strategies, each of them involving some risks (Cohen, Reisinger and Wang, 2020). Alternatively, trading such options necessitates a deeper understanding of market strategies and risk management. Similarly to futures, the delivery details and option margins can also differ depending on which contract is selected.

Futures curves

Market Condition (Backwardation or Contango): The curve shape can tell whether the futures market is backwardated or in contango (Galán-Gutiérrez and Martín-García, 2022). When future prices are lower than the current spot price it is called backwardation, a shortage condition, or high demand now. Contango is a condition where future prices are higher than the current spot price as an implication that there will be oversupply or low immediate purchase demand (Coral and Mithöfer, 2023).

Relation to Theories: Futures prices are related to the costs of storing a commodity in accordance with The Theory of Storage; according to The Theory of Normal Backwardation, futures prices should be below the spot price expected at some time (Nair, Kumar and Inani, 2021).

Market Implications: The curvature shape of the futures curve reveals some information about what kind of future supply/demand is forecasted (Han et al., 2023). While a contango market could signal an abundant supply or lack of demand in the future, backwardation may point to limited supplies and high current demand.

Backwardation or Contango in Oil Markets

• A backwardated market refers to a situation where the futures prices are below or lower than what is expected for future spot prices (Carter and Revoredo-Giha, 2022). This situation usually points to a high immediate demand need, shortage of the product or costs incurred from stocking it.
• In a contango market, the futures prices are above spot values. This often implies that the market anticipates an oversupply or reduced future demand, with lower holding costs (Bouchouev, 2020).
• These market conditions can be seen from the futures curves. A curve that rises (prices rising for longer-dated contracts) exhibits contango, whereas a declining curve in price means backwardation.

The cost of carry (including storage costs, insurance and interest forgone on money locked up) and the convenience yield (the non-monetary benefit of holding physical stockings crucial in forming these curves. Contango is a situation where the cost of carry level increases relative to convenience yield while backwardation can be characterized by an excessively high value for the convenience return over that for carrying charges (Considine, Galkin and Aldayel, 2022).

Pricing crude oil futures options

American Call Option Price: Approximately $12.45

American Put Option Price: Approximately $18.55

The futures prices binomial tree is between $35.8 and 170.23 dollars range. The minimum prce of the call option is zero, and its maximum priceis $84.34 while that for put options ranges from 0 to$50.

Option Valuation at Each Node

In the American Call Option, at each node of binary tree nodes option value is determined by maximum between intrinsic values (when opted from that point) and present worthily anticipated expected options price in abutting Step (Lin and Almeida, 2021). This takes into account the early exercising, an American option characteristic. As the value at each node for the American Put Option is given by, (present value of expected option valye in next step under risk-neutral measure). This method also takes into account early exercise.

Hedging oil price risk by governments

Hedging Oil Price Risk by Governments: A Case Study of Practices and Possibilities.

Though hedging against oil price risk is a common practice in the business of oil and gas companies, it has not become popular among governments; especially whereby overproduction causes GDP to decline (Daniel, 2020). To realize how governments tend to avoid using derivatives as a means of hedging their oil price risks requires looking at a number of economic, political and even social aspects.

Reasons for Governmental Hesitance in Using Derivatives

• Expertise and Resource Constraints: A key factor for governmental reluctance is the elements of specialized knowledge and necessary resources that make hedging effective (Grima, Spiteri and Romānova, 2020). Such governments, especially in less developed countries may lack the required expertise and infrastructure to be able to indulge in exotic financial transactions that derivatives portray.
• Political and Regulatory Barriers: Political factors are very significant. Governments operate in the glare of public pressure and are therefore apprehensive about using financial tools that might be characterized as guile (Mansoor, 2021). Additionally, regulatory and legal environments in the vast majority of countries may not be conducive to using derivatives either because of overt prohibitions or lacklustre regulation.
• Public Perception and Transparency: There is always a challenge in the perception of the public, hedge activities could be misconstrued as gambling with national resources. This perception can be intensified by the opacity of derivatives markets resulting in low public trust and support.
• Benefits of Derivatives for Governments and Society
• Although substantial obstacles hamper the practical use of market-based derivatives for oil price hedging, this type of instrument can present some unique benefits to governments and society as a whole (Fabozzi, Shiller and Tunaru, 2020).
• Revenue Stabilization: Hedging ensures the stabilization of government revenue from oil, which leads to a more efficient budgeting and economic planning process. This is especially important for oil-rich countries in the sense that it saves them from unpredictability which characterizes oil markets.
• Economic Stability: Through risk minimization of the changes caused by oil prices, governments can shield their economies from global oil market forces (Anbumozhi, Kimura and Thangavelu, 2020). This is particularly critical to oil-exporting or importing nations where price hikes can have far-reaching economic implications.
• Public Welfare Enhancement: Government revenue stabilization through proper hedging helps in more reliable financing of the public utilities and social security measures that translate into enhanced overall welfare (Stephane, Jun and Julie, 2020).

Current State and Development of Derivatives Markets

The derivatives markets, which include exchanges as well as over-the-counter (OTC) trading have changed significantly to provide a wide range of tools for risk mitigation including the oil price risks (Jayeola, 2019).

• Market Evolution: These markets have come a long way in terms of their size and sophistication to offer many instruments that can be used for different hedging strategies.
• Increased Access and Transparency: The growth of regulatory reforms has increased market transparency, and these markets have become more accessible to a wider group of participants.
• Application Challenges: However, despite these improvements, there are still major challenges that persist in applying to use for governmental purposes. Such is the complexity of financial instruments, the requirement for specialisation and the sensitivity to the use of derivatives by political stakeholders as well as public actors (Havemann, Negra and Werneck, 2022).
• Opportunities for Development: Opportunities for capacity building within governmental frameworks are tremendous. In international collaborations in education programs, governments can achieve the necessary expertise to be involved more effectively in these markets.

Further, derivatives for hedging on oil price risk provide significant advantages, the governments must carefully evaluate their capabilities, regulatory system and political commitment level of people along with public transparency issues (Zhang, 2020). The developing derivatives markets present opportunities and dangers to governments, especially those countries where oil is a key economic driver.

References

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Bouchouev, I. (2020). From risk bearing to propheteering. Quantitative Finance, 20(6), pp.887–894. doi:https://doi.org/10.1080/14697688.2020.1740428.

Carter, C.A. and Revoredo-Giha, C. (2022). The Theory of Normal Backwardation and Financialization of the Futures Markets. Natural resource management and policy, 5(4), pp.391–414. doi:https://doi.org/10.1007/978-3-030-77760-9_16.

Cohen, S.N., Reisinger, C. and Wang, S. (2020). Detecting and Repairing Arbitrage in Traded Option Prices. Applied Mathematical Finance, 27(5), pp.345–373. doi:https://doi.org/10.1080/1350486x.2020.1846573.

Considine, J., Galkin, P. and Aldayel, A. (2022). Inventories and the term structure of oil prices: A complex relationship. Resources Policy, [online] 77(7), p.102657. doi:https://doi.org/10.1016/j.resourpol.2022.102657.

Fabozzi, F.J., Shiller, R.J. and Tunaru, R.S. (2020). A 30-Year Perspective on Property Derivatives: What Can Be Done to Tame Property Price Risk? Journal of Economic Perspectives, 34(4), pp.121–145. doi:https://doi.org/10.1257/jep.34.4.121.

Galán-Gutiérrez, J.A. and Martín-García, R. (2022). Fundamentals vs. Financialization during Extreme Events: From Backwardation to Contango, a Copper Market Analysis during the COVID-19 Pandemic. Mathematics, 10(4), p.559. doi:https://doi.org/10.3390/math10040559.

Grima, S., Spiteri, J. and Romānova, I. (2020). A STEEP framework analysis of the key factors impacting the use of blockchain technology in the insurance industry. The Geneva Papers on Risk and Insurance - Issues and Practice, 13(4). doi:https://doi.org/10.1057/s41288-020-00162-x.

Han, X., Zhu Guang, Zhao, L., Du, R., Wang, Y., Chen, Z., Liu, Y. and He, S. (2023). Ollivier–Ricci Curvature Based Spatio-Temporal Graph Neural Networks for Traffic Flow Forecasting. Symmetry, 15(5), pp.995–995. doi:https://doi.org/10.3390/sym15050995.

Jayeola, O. (2019). Inefficiencies in trade reporting for over-the-counter derivatives: Is blockchain the solution? Capital Markets Law Journal, 15(1), pp.48–69. doi:https://doi.org/10.1093/cmlj/kmz028.

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