ENERGY DERIVATIVES The basic building blocks for all derivative contracts are the Futures and swaps

contracts. For the energy markets these are traded in New York NYMEX, in Tokyo TOCOM and on-line through IntercontinentalExchange. A future is a contract to de liver or receive oil (in the case of an oil future) at a defined point in the fu ture. The price is agreed on the date the deal/agreement/bargain is struck toget her with volume, duration, and contract index. The price for the futures contrac t at the date of delivery (contract expiry date) may be different. At the expiry date, depending upon the contract specification the 'futures' owner may either deliver/receive a physical amount of oil (this is a rare occurrence), they may s ettle in cash against an expiration price set by the exchange, or they may close out the contract prior to expiry and pay or receive the difference in the two p rices. In futures markets you always trade with a formal exchange, every partici pant has the same counterpart. Weather derivative Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated w ith adverse or unexpected weather conditions. The difference from other derivati ves is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Farmers can use weather derivatives to hedge against poor harvests caused by fai ling rains during the growing period, excessive rain during harvesting, high win ds in case of plantations or temperature variabilities in case of greenhouse cro ps; theme parks may want to insure against rainy weekends during peak summer sea sons; and gas and power companies may use heating degree days (HDD) or cooling d egree days (CDD) contracts to smooth earnings. A sports event managing company m ay wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold. Inflation derivative Inflation swaps are typically priced on a zero-coupon basis (ZC) (like ZCIIS for example), with payment exchanged at the end of the term. One party pays the com pounded fixed rate and the other the actual inflation rate for the term. Inflati on swaps can also be paid on a year-on-year basis (YOY) (like YYIIS for example) where the year-on-year rate of change of the price index is paid, typically yea rly as in the case of most European YOY swaps, but also monthly for many swapped notes in the US market. Even though the coupons are paid monthly, the inflation rate used is still the year-on-year rate. Options on inflation including interest rate caps, interest rate floors and stra ddles can also be traded. These are typically priced against YOY swaps, whilst t he swaption is priced on the ZC curve. Asset swaps also exist where the coupon payment of the linker (inflation bond) a s well as the redemption pickup at maturity is exchanged for interest rate payme nts expressed as a premium or discount to LIBOR for the relevant bond coupon per iod, all dates are co-terminus. The redemption pickup is the above par redemptio n value in the case of par/par asset swaps, or the redemption above the proceeds notional in the case of the proceeds asset swap. The proceeds notional equals t he dirty nominal price of the bond at the time of purchase and is used as the fi xed notional on the LIBOR leg.

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