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Investigate energy derivatives and the underlying price process
Table of Content
EXECUTIVE SUMMARY 3
1.0 INTRODUCTION 3
2.0 THE CHARACTERISTIC OF DERIVATIVES INDUSTRY 4
2.1 The development and impact of financial derivatives 4
2.2 Risk of Financial Derivatives 5
3.0 THE ENERGY DERIVATIVES 6
3.1 The development of energy derivatives 6
3.2 The main characteristics of energy derivatives 7
3.3 The representative energy derivatives 8
4.0 THE PRICE PROCESS OF ENERGY DERIVATIVES 9
4.1 Factors impact on the price process of energy derivatives 9
4.2 Major risks of energy derivatives 11
5.0 CONCLUSION 12
REFERENCES: 12
Executive SummaryThe Essay is provided by UK Assignment http://www.ukassignment.org
Financial derivatives are important financial products in the global financial market, despite the benefits get from the using of the financial derivatives, there are also many potential risks existed in the using of financial derivatives. In which the energy derivatives are having more risk than others since there are many factors impact on the market. This report will firstly analyse the main characteristics of financial derivatives industry in the aspect of the impact, advantages and risk. And then, it will particularly analyse the development and characteristics of some representative energy derivatives. Also, this report will discuss the underlying price process of energy derivatives by the analysis on different factors impact on the different aspects of energy derivatives. At then end of the report, a brief conclusion has been give as a main achievement of the report. The Essay is provided by UK Assignment http://www.ukassignment.org
1.0 Introduction
Financial derivatives as one of the most efficient ways of the risk management have been widely used all over the world. The financial derivatives develop on a large scale, and play a significant role in the international finance. According to Damodaran & Subrahmanyam (1992), as financial contracts, financial derivatives have caused great challenge in definition, recognition, measurement and disclosure of traditional financial accounting elements. There are pros and cons of applying financial derivative within the market. Along with the development of globalization and modern economy, there are massive financial risks appears, that requires the frequent application of the financial derivatives because the application of financial derivatives could probably help the businesses to prevent the potential risks. Nevertheless, using of the financial derivatives could also expose the user to some other risks. Thus, how to manage the financial derivatives becomes increasingly important. (Das, 1993; Bodi, Kane and Marcus, 1989). There are different types of financial derivatives along with the development of modern economy, which have their own specific characteristics and prices process. Energy derivatives as an important financial derivative in contemporary, is becoming more advanced through the development of derivatives. Since the high profit in energy derivative, it has been considered to have the most profitable and high payback in the derivatives (Hull, 2005). In order to analyze the energy derivatives, the characteristic of financial derivatives will be discussed first.
2.0 The characteristic of derivatives industry
2.1 The development and impact of financial derivatives
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The financial derivatives have directly impact on the corporation; financial derivative is a good strategy of risk management. Back to the early 1990s, Nance, Smith & Smithson (1993) found a statistically positive relationship between tax credits and the application of financial derivatives. Later on, Dolde (1995) reported a positive and clear relationship between tax loss carry forwards and the use of risk management instruments, such as the hedging. It suggested that the using of financial derivatives could transfer the risk for the participants. After that, Dixon and Bhandari (1997) found that financial derivatives are broadly implemented, and the stability of international financial markets could be severely damaged without derivatives. At the end of last decade McAllister and Mansfield (1998) analyzed the role and potential of financial derivatives investment. They concluded that the application of financial derivatives could mitigate many issues that associated with direct property investment. Later on, McAllister and Mansfield (1998) mentioned that the development of PICs which refers to property index certificates has “broken the ice” with investors and should generate increased interest in and use of derivative products in the property sector by UK and overseas institutional investors. In the early of this century, Fender (2000) explored some of the corporate finance foundations of monetary economics, and investigated the impact of financial derivatives on the monetary transmission mechanism. And he finally put that financial derivative has a significant impact on credit channel and monetary policy. Following this, El-Masry (2006) indicated that the financial derivatives are broadly The Essay is provided by UK Assignment http://www.ukassignment.org implemented by a large amount of companies, and especially for public business and large companies. In addition, Freeman et al (2006) found that the credit derivatives market is dominated by large banks and insurance companies who trade credit exposure among themselves. More recently, Eckstein et al (2008) examined the impact of firms using derivatives applying Statement of Financial Accounting Standards (SFAS) No. 133, the results showed that the significant negative unexpected returns were observed around earnings announcement dates. Moreover, Klimczak (2008) provided a comprehensive empirical assessment of major contemporary corporate hedging theories. This research based on a sample of 150 companies listed on the Warsaw Stock Exchange, and then identified characteristics shared by firms that use hedging. Based on all of above argumentations put by scholars and economists, clearly, financial derivatives have a lot of impacts as well as merits. The Essay is provided by UK Assignment http://www.ukassignment.org
2.2 Risk of Financial Derivatives
Despite financial derivatives have significantly positive effects, there are also some risk existed in the using of the financial derivatives. There are many criticisms on the financial derivatives. Firstly of all, financial derivatives will possibly bring the large loss due to the use of leverage, or borrowing of the financial derivatives investors. Derivatives are complex method and design to be more insured for the transformation of the risk, it could be used to reduce the risk but also create more potential risks for the investors (Laker, 2008). He stated that “the derivatives allow investors to earn large returns from small movements in the underlying asset's price”. And, this large amount of reward would be an attraction even for individual investors. However, financial derivatives will possibly also cause huge amounts of risk for investors, especially for those who are inexperienced. Further more, as the large value of the financial derivatives, it is dangerous for the investors that could have a big loss on their capital through the trading and operation of financial derivatives. According to the annual report of Berkshire Hathaway Inc (2002), it is possible that such loss in financial derivatives could lead to the potential economic crisis for the whole world as the large value of the financial derivatives. In addition, according to Rawles (2006) financial derivatives could also call for a recession or depression of the financial market by the irregular operation within the market or the big risks happened in the market.
3.0 The energy derivatives
3.1 The development of energy derivatives
According to Fusaro and Wilcox (2000), the energy trading is growing with the development of the global economy. The trading of financial derivatives would have direct influence on the trading of energy market, such as the oil, natural gas and electricity. And the application of internet would strength the impact since the information is more transparent. The price of energy derivative products is becoming more complicated and complex. The modern oil market is becoming free in the recent 20 years.(这句话在这里什么意思？与上下文有何关系？) According to The Essay is provided by UK Assignment http://www.ukassignment.org McCann and Nordstrm (1995), commercial banks are rarely involved in the trading of energy market, with an estimation of 5-10% percent. However, such involvement is also important both for the energy product and the market participants. Since the energy products are almost limited and with a high flow both in the price and the quantity, the energy derivatives market are having more factors impact on it. Because of the instability of the energy market, the banks are playing an important role in the regulation and improvement of the market. The hedging is a significant method for the transfer of the market risk for energy derivatives in banks; though it is not directly lead for the energy prices, it will lower the risk for the investors of energy derivatives. According to Clewlow and Strickland (2000), since the participation of the banks in the energy market, the energy derivatives products are becoming more popular and less risk for the investors. The energy derivatives market is now in a tendency of becoming more regular and standard which has a relatively lower risk with a higher payback. In the international market, the interest rate is also an important factor which has significant impact on the development of energy trading market, such as the foreign currency exchange could determine the risk level of the market to some extent. Thus, banks are playing an important role in the development of energy trading market. It could improve the product line and strengthen the credit of the barrowers thus to ensure the capital for the investors in energy trading market. According to Kendall (1999), since the energy is growing more mature under the safeguard of banks, the innovations of the energy trading market is also having more potential challenge for the market. The innovations within energy trading market could bring more profit and less risk for the investors 这段麻烦您修改一下。首先innovation到底是什么一直没提，其次蓝色部分的文字不太明白您要表达什么意思. Investors’ profits are dependent on the influence of banks and the innovations along with the development of energy trading market. Such risk management strategies are playing a great role in the enhancement of the profit for investors in energy market (McCann and Nordstrm, 1995). Therefore, the energy trading market is becoming more regular with higher profit and more safeguard under the increasingly involvement of banks both in domestic market and internationally.
The Essay is provided by UK Assignment http://www.ukassignment.org 3.2 The main characteristics of energy derivatives
Energy derivatives can be divided to the spot, exchange and the OTC market which are similar to the interest rate market. This market is generally affected by the structure of crude oil and natural gas market. The energy derivatives products are different from other financial derivatives as it has a real market to accordance with. The energy derivatives products would flow with the market of crude oil and natural gas, both in supply quantity and the prices. Despite the strong relation with crude oil and natural gas market, energy derivatives products are having the following characteristic in general. First of all, as the energy derivatives products are new in the financial derivatives market, it has more risks in the holding and trading of the products. The energy derivatives market is less mature compare with other financial derivatives; it still needs many improvements within the market. Secondly, as the energy products are in limited quantity, the supply and the price of energy products are not stable which would flow up and down according to the supplier of the oil and natural gas, such as the members of OPEC who are playing an important role in the energy derivatives market. The decision of OPEC would lead directly influence to the energy derivatives market. Moreover, energy derivatives are still in a rapid development period compared to other mature financial derivatives. There will be many innovations and new strategies in the development of energy derivatives market (Eydeland and Geman, 1998).
3.3 The representative energy derivatives
According to Hull (2005), in present day society, the most representative energy derivatives can be generally divided into two kinds of market, one is the over the counter energy market and the other is the exchange trade market. In details, the over the counter market includes the average OTC energy options and energy swaps, in which OTC options and exchange of energy is unique and all are basically the average price options. This is popular for many years (Das, 1993). Whereas the exchange trade market is also very popular in contemporary market includes the crude oil, natural gas and electric. According to Fitzgerald and Pokalsky (1995), the crude oil and natural gas marker is the most common energy derivatives in people’s life, and the futures in electricity promise to be the next sector of the energy marketplace to be traded on an exchange. The market has already involved many people; and it is still developing rapidly. In this report, it would particularly focus on the crude oil and natural gas market. According to Hull (2005), the demand of crude oil is very large in contemporary world, estimated 8.9 million tones every day from all over the world. Thus, the trading of crude old derivatives is becoming popular. The most representative market for the exchange trade of crude oil would be the New York Mercantile Exchange (NYMEX) and the International Petroleum Exchange (IPE) which trade the oil futures and futures options contracts. And the natural gas is also very demandable for the contemporary market. New York Mercantile Exchange (NYMEX) also trade number of contract of natural gas options everyday. The Essay is provided by UK Assignment http://www.ukassignment.org
4.0 The price process of energy derivatives
4.1 Factors impact on the price process of energy derivatives
According to Trabia (1992), the price of energy derivatives are determined by many factors. Due to the absence of arbitrage, reduce costs and model forecasts, the price of derivatives products would be different from the storage of the spot price and the related financing costs. In the basic model of price process of derivatives, the spot price might be the only source to modify the uncertain condition. The implementation of the spot price model is also positive in the prediction of the energy derivatives products prices, and the model can be further extended for more use to get a more reliable results. However, the basis model of spot price only plays a role in a short term of price process of energy derivatives. In a long term, it is not significant. As the different characteristics of the energy derivatives market, the predict model can not be full implemented in the long term due to the unstable of the crude oil and natural gas market. Gabillon (1995) claimed that demand of the crude oil and natural gas in energy derivatives market is inelastic. No matter the distributions companies, the oil refining companies and the end users can not impact the supply of the crude oil and natural gas. They are in a limited quantity supplied which arranged by the suppliers. However, even the oil supplier can not really determine the supply quantity of the crude oil and natural gas; they are more accordance with the natural and unstable situations. Thus, the supply, demand and price curve can not be applied in the energy market. And without the oil supply, the energy derivatives also become nonexistence. The market is determined by the supply, the demand and price would not impact the market. The Essay is provided by UK Assignment http://www.ukassignment.org
Hull (2005) developed a reasonable model for the energy prices, which showed in the following figure 1. In which “where S is the energy price, and a and a are constant parameters, the 9{t) is representative for the seasonality and trends.” In this model, the parameters are changeable for the different types of energy from 0.5 to 20 and 20% to 200% or greater from crude oil, natural gas and electricity prices.
Figure 1 reasonable model for the energy prices
Source: Hull (2005)
请解释与energy derivative的联系。The Essay is provided by UK Assignment http://www.ukassignment.org
The energy market is also impacted by many other factors, such as the exchange of foreign currency and interest rate especially in international aspect. Take the crude oil market for instance, compared to the free market of natural gas, crude oil is more mature, but still can be traced back to about the mid-1970. Oil is dollar-denominated international. This factor caused chagrin among OPEC (and other international) producers during the dollar's weakness. Following figure 2 shows the price of crude oil in U.S. dollar future during a certain period. Although many other factors affect the price of crude oil, it can be seen is often accompanied by a weaker U.S. dollar increased the price of crude oil (Barnaud and Dabouine, 1995).
Figure 2 the price of crude oil of the U.S. dollar index future during the period 2/1/95 to 8/21/95
Source: McCann and Nordstrm (1995)
4.2 Major risks of energy derivatives
Therefore, the flow of price of oil and natural gas would be the major factor impact on the trading of energy derivatives. Since the crude oil and natural gas is very unstable, the market is with many potential risks. No matter buying, selling, marketing, trading and designing of the energy derivatives are exposed the participations to various risks. Firstly, as the price of the crude oil and natural gas are transparent in the market in all over the world, the energy derivatives are bearing the risks of price exposure. The price of the crude oil and natural gas in controlled not only by the provider organizations but also by the macro environment. The imbalance in supply and demand of crude oil and natural gas, the bad weather conditions would also affect the output of the quantity of crude oil and natural gas. In which the local disturbances in the Asian country in OPEC members’ country would be a big risk impact on the energy derivatives market. Secondly, the hedging using to reduce the risk by the interest rate, foreign exchange trade might also call many potential risks for the energy derivatives market. The hedging would affect the flow of the energy derivatives market. Thirdly, as the price of crude oil and natural gas is very unstable and uncertain, the energy derivatives are exposed to more unstable risks compared to other financial derivatives. And fourthly, the energy derivatives market also has the common risks which the financial derivatives all have, such as the risk in hedging and the change of market strategy in the trading (Falloon, 1995).
5.0 Conclusion
In conclusion, the energy derivatives are very important with potentially high profit and high risk in the emerging market, which has many different characteristics. Energy derivatives products as the newer in the financial derivatives market, have many risks compared to mature financial derivatives. It is strongly influenced by the real market of crude oil and natural gas. And there will be more innovations and different products along with the further development of energy derivatives market. By the specific analysis on crude oil market, the report finds that although the energy derivatives are having high profit, it also has many risks in it. And since the market in very complicated and unstable, the underlying price process of the energy derivatives is also different from others and is strongly influenced by the real market and flow of the world economy. The Essay is provided by UK Assignment http://www.ukassignment.orgThe Essay is provided by UK Assignment http://www.ukassignment.org
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