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dERIVATIVES ANd dERIVATIVES MARkETS

D erivatives are nancial instruments. ey are sometimes considered a modern inno- vation, even though they have been traded for millennia. It is indeed the case that the scale and scope of derivatives trading has mushroomed in recent years, but these products are as old as - nancial trading itself.

might enter into a contract to sell oil to Ms. B for delivery in January 2010 at a xed price of $70/ barrel. is agreement to sell in the future at a

  • xed price is a forward contract. Typically, the

buyer and the seller agree on a forward price such that the value of the contract is zero, so no money changes hands when the contract is signed.

  • e name “derivative” gives a sense of their na-

ture. ese are nancial instruments that have a cash ow that is derived from some “underlying” instrument. For example, a gold forward con- tract—an agreement to buy or sell gold at a fu- ture date—has a cash ow that is dependent on— derived from—the price of gold. Another name for derivative—“contingent claim”—conveys the same idea. e payo to a derivative is contingent on the price of some underlying instrument.

  • e instruments that underlay derivatives con-

tracts were once limited to a relatively narrow range of physical commodities, such as corn or gold. Beginning primarily in the early 1970s, however, derivatives have been introduced on just about everything conceivable, including en- ergy commodities, nancial instruments such as stocks and bonds, and even the weather.

  • ere are a variety of basic types of derivatives.

  • e most fundamental type of derivative is a for-

ward contract. For instance, in July 2009, Mr. S

Another, slightly more complicated derivatives product is an option. Whereas a forward contract creates a binding legal obligation to the buyer and seller, an option gives the buyer a choice. For in- stance, Ms. B might enter into a call option con- tract to buy oil in January from Mr. S at a xed price of $70/barrel. If the price of oil in January is above $70, say $75, Ms. B will exercise her option to buy at $70 and pocket a $5 payment. In prac- tice, she may realize this prot by buying at $70 and immediately selling into the market at $75.

In contrast, if the price of oil in January is less than $70, she will not exercise her option. Since options have a heads-I-win-tails-I-don’t-lose character, a buyer is willing to pay a positive price for the op- tion, and the seller (who faces a heads-I-lose-tails- I-don’t-win situation) will only enter the contract if paid a positive price upfront. is upfront pay- ment is called the option premium, and it depends on the characteristics of the option (e.g., its time to expiration, the xed “strike” price of the option, the type of option) and on the characteristics of

E N E R G Y S E C U R I T Y I N I T I AT I V E

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