Hedging Instruments Explained

Definition

A contract to buy or sell a commodity at a price agreed today, with delivery and payment at a future date. Traded on an exchange (e.g. CME, ICE); standardized terms; daily margining. First futures: Chicago Board of Trade, 1848 (Corn).

Example — WTI crude

Buy 2 lots WTI Crude DEC-22 at 50 USD/bbl on CME. One lot = 1,000 barrels → 2,000 barrels. Locked in at 50 USD/bbl until expiry. Physical delivery: pay 50 × 2,000 = 100,000 USD. Paper settlement: gain/loss = (Market price − 50) × 2,000.

Typical uses

• Hedge standardised commodity exposure (crude, gas, power).
• Speculate on price direction with high liquidity.
• Offset physical positions before delivery.

Pros & cons

• Pros: Central clearing (low counterparty risk), transparent prices, liquid, linear payoff.
• Cons: Margin calls can impact cash flow; standardised terms may not match exact physical need.

Margining & risk

• Initial margin: Posted at trade; covers potential loss over a short period.
• Variation margin: Daily mark-to-market; gains credited, losses debited (margin call if balance falls below maintenance level).
• Clearing house: Becomes counterparty to both sides; mutualised default fund; greatly reduces counterparty risk.
• Margin calls: If price moves against you, you must top up; can create cash flow pressure.

Key formulas

Key features

• Linear payoff: PNL moves in line with price; no optionality (see chart below).
• Settlement: Financially (cash) or physically; most positions are offset before expiry.
• Standardized: Quality, delivery location, size — to promote liquidity.
• ETRM: Interfaced from trade platforms (e.g. Bloomberg, Trayport); used to hedge physical or in speculation books.

Definition

Same idea as futures — agree today, deliver later — but traded OTC with flexible terms and no daily margining. You trade directly with the counterparty.

Typical uses

• Custom quantity, delivery date, quality or location that exchange futures don’t offer.
• Long-term supply or offtake (e.g. PPAs, physical supply agreements).

Pros & cons

• Pros: Bespoke terms; no daily margin calls; linear payoff like futures.
• Cons: Higher counterparty risk; less liquid; settlement risk at maturity.

Margin & counterparty risk

• No daily margining: Cash flows only at settlement; no mark-to-market top-ups in between.
• Bilateral risk: If the counterparty defaults before settlement, you may not get paid or delivered.
• Mitigation: Collateral (CSA), credit limits, and dealing with rated counterparties.

Futures vs Forwards

Aspect	Futures	Forwards
Venue	Exchange (e.g. ICE)	OTC (over the counter)
Terms	Standardized	Flexible, negotiable
Counterparty	Clearing house in between	Direct with counterparty
Counterparty risk	Very low	Higher
Margin	Daily mark-to-market, margin calls	Typically none until settlement
Settlement	Daily PNL; physical or cash at expiry	Mainly on one date

Example — Power Purchase Agreement (PPA)

Building a power plant; you want a steady buyer (e.g. municipality) for 15–20 years. You enter a long-term PPA (a forward) for part of the output; for the rest you might use futures. Forwards fill the gap when exchange products do not match tenor or structure.

Definition

Two parties promise to exchange the resulting cash flows from their respective legs. One leg is often fixed (agreed at trade date), the other floating (e.g. LIBOR/SOFR or a commodity index).

Typical uses

• Hedge price index differentials (e.g. jet fuel vs crude, gas index vs fixed).
• Convert floating-rate exposure to fixed (or vice versa) in one trade.
• Commodity or interest rate flows over many settlement dates with a single contract.

Pros & cons

• Pros: One contract covers multiple periods; net payments reduce cash flow; can be cleared (lower counterparty risk) or bilateral.
• Cons: Bilateral swaps carry counterparty risk; cleared swaps require margin; documentation (e.g. ISDA) and fixings to manage.

Margin & counterparty risk

• Cleared swaps: Central counterparty (CCP); initial and variation margin; greatly reduces counterparty risk; margin calls can affect cash flow.
• Bilateral (OTC) swaps: Direct counterparty risk; often collateralised via CSA; no daily margin unless agreed.

Example — Jet fuel swap

Airlines often hedge jet fuel with a commodity swap: they pay a fixed price per unit and receive the floating (index) price. Net each period = (Floating − Fixed) × Volume. This locks in cost using a standard index (e.g. Jet CIF NWE).

Interest rate swap — Day 0 (inception)

On the day the swap is agreed:

• Terms are set: Notional amount (e.g. 1 million GBP), fixed rate (e.g. 4%), currency, and the floating-rate index (e.g. LIBOR) and fixing schedule.
• No cash changes hands at inception — the swap has zero value at the agreed fixed rate vs the then-prevailing floating rate.
• Contract is documented (e.g. ISDA); both parties are now committed to exchange payments on each settlement date.

Settlement date

On each settlement date (e.g. every 3 or 6 months):

• Fixing: The floating rate (e.g. LIBOR) is observed or “fixed” on the fixing date (usually a few days before settlement). That rate applies for the period just ending.
• Calculate legs: Fixed leg payment = Notional × Fixed rate (known from Day 0). Floating leg payment = Notional × Floating rate (the rate just fixed).
• Net payment: The two amounts are netted. One party pays the other the difference (e.g. if floating > fixed, the fixed-rate payer receives the net from the floating-rate payer).
• Cash flow: Only the net amount is paid; no exchange of full notional.

Key formulas

Cash flow diagram

Below: fixed vs floating legs and the net payment. Notional and fixed rate are set at Day 0; change the floating rate to see how payments and net result change.

Definition

A right (not obligation) to buy or sell at a strike price. You pay a premium. Call = right to buy; Put = right to sell. Underlying = the asset (e.g. WTI futures).

Typical uses

• Cap downside while keeping upside (e.g. refiner capping feedstock cost with calls).
• Optionality on volume or timing (e.g. gas storage swing options).
• Protection with limited loss (premium) and unlimited or large upside (calls).

Pros & cons

• Pros: Limited loss (premium); asymmetric payoff; flexibility (e.g. exercise when it suits).
• Cons: Premium cost; short options can have large margin and uncapped liability.

Margin & risk

• Long options: You pay premium upfront; max loss = premium; no margin calls for the long.
• Short options: Seller may face margin (and variation margin) and uncapped loss if price moves against them.
• Clearing: Exchange-traded options are cleared; OTC options are bilateral (counterparty and possibly collateral).

Example — Refiner cap

Refiner wants to cap purchase at 60 USD/bbl. Buys call options, strike 60, premium 2 USD/bbl. 1,000 contracts × 1,000 bbl = 1m bbl. Premium paid = 2,000,000 USD. Break-even = Strike + Premium = 62 USD/bbl.

Example — Gas storage swing option

Swing options give the holder the right to take (or put) gas within a volume band and over a period at a strike. Used for storage: you can inject/withdraw within contract limits when price is favourable. The optionality (when and how much) is valuable; premium reflects that. ETRM models volume bands, nomination dates and constraints.

Call vs put payoff

Call: profit when underlying > strike (minus premium). Put: profit when underlying < strike (minus premium). Below: schematic payoff at expiry (long call = capped loss, upside; long put = capped loss, downside).

Key formulas

Option scenario calculator

Profit is unlimited above the strike (the line slopes up with price). Loss is capped at the premium below the strike (the flat floor on the graph). The strike establishes this floor — below it the call expires worthless, so you lose only what you paid, no more.

Option Greeks (in words)

• Delta — How much option value changes when underlying price changes; how much underlying to hold to hedge the option.
• Gamma — Rate of change of Delta when underlying changes; high Gamma means more frequent hedging.
• Theta — Time decay; rate at which option loses value as expiration nears.
• Vega — Change in option value when implied volatility changes; higher volatility → higher option price.

Black–Scholes

Fischer Black and Myron Scholes won the Nobel Prize in Economics for this work (1997).
The formula gives a theoretical fair value for a European call option.
It assumes the underlying price follows a log-normal process and that the option can be continuously hedged with the underlying.
The call value depends on underlying price, strike, time to expiry, risk-free rate, and volatility.
Volatility is central: higher volatility means a higher option premium.