Once the board has authorized and established policies and procedures for the risk management program, senior management must execute the strategy; in other words, they must start using energy derivatives to hedge. As touched upon in previous chapters, hedging is the process in which an organization with energy price risk takes a position in a derivative instrument swaps, options, futures that gives an equal and opposite financial exposure to the underlying physical position to protect against major adverse price changes. The volumetric price exposure of the derivatives hedging instrument should be equal and opposite to the price exposure of the physical energy commodity that the organization wishes to reduce its price risk exposure in.
An energy derivative is a derivative contract based on derived from an underlying energy asset, such as natural gascrude oilor electricity. Major players in the energy derivative markets include major trading houses, oil companies, utilities, and financial institutions. Energy derivatives were criticized after the financial crisiswith critics pointing out that the market artificially inflates the price of oil and other energy providers.
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A commodity swap is a contract where two sides of the deal agree to exchange cash flowswhich are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodityand they have been trading in the over-the-counter markets since the middle of the s. A commodity swap consists of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or agreed-upon commodity index, while the fixed-leg component is specified in the contract.
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A swap is an agreement to settle in cash the difference between the fixed price of the derivative now and the floating price of the said commodity at a future date. End-users need to hedge the prices at which they can purchase crude oil. This tool will enable them to lock in the price of the crude oil at which it was purchased for the coming months. In recent years, crude and product prices have fluctuated extensively in response to extreme weather conditions or political crises.