PDF Ebook Option Trading and Oil Futures Markets
The establishment, of a very successTu1 crude oil futures market by the New York Mercantile Exchange (NYMEX) has introduced a new and important factor into the process of oil price formation. Trading in crude oil Tutures has been expanding very rapidly and now provides an instrument that enables economic agents to hedge against short-term price risks. The NYMEX is also a reading mechanism ior oil price discovery in the short term.
However, as is the case for most tutures markets, NYMEA contracts extend over a rr’airly short time horizon (eighteen months in theory hut only Tour months in practice), and there is a lack of fiexibiiity prevailing once a hedge has been initiated ( a price is rigidly fixed from then on no matter what the market does afterwards).
These features have induced some institutions to issue instruments that enable agents to manage price risks with more f1exibilit”y than might otherwise be possible on futures markets. In 1985, the Morgan Stanley finance house proposed dealer (or “tailormade”) options to its customers and some of these dealer options are understood to involve Brent.
In September i985 Phibro launched its “warrants on crude oil”. Then, in June 1986. Standard Oil issued oil-indexed bonds which were followed two weeks later by a similar security issued by 1J.S.X. Ail these instruments display a common feature: they are genuine options or they can be described as option-based instruments.
Last but not least, the NYMEX itself obtained an authorization from %he Commodity Futures Trading Commission ( CF'l'C 1 , the independent, government. regulatory commission 1.n charge of US commodity markets, to g o ahead with the launch of options on its own crude oil and heating oil. kt-utures contracts; and lrading in options on the crude oil futures contract, began on 14 November 1986, Jiurthermore, the European Options Kxchange (ECJEI in Amsterdam plans to begin trading gas oil according to IPE specitications from 1 April 1981.
Thus, options or oil-indexed bonds now complement, the structure or the petroleum market by oki-tering more Tiexibility than was previously available in oil futures or forward markets. In this respect, they may have an important role to play.
This paper includes a description o f the mechanics of options trading and, in particular, emphasizes the di.kTerences between futures and option contracts (Sectpions I and 111. A major issue in options trading is their pricing. Consequently, Section I11 discusses the main determinants of option premiums and, in Section IV, there is a short presentation o k option pricing models, in particular, the famous Black and Scholes formula. Section V tries to apply the Black and Scholes model to the Phibro proposal and shows that, although Phibro did use such a model, it failed to anticipate tuture price volatility correclly. Section VI tries to give some insight on how option contracts may complement Tutures contracts and Section VI1 describes the present NYMEX crude oil option contract. As crude oil options have just started being exchange-traded, the data available are too limited for empirical research. However, we have been able to analyse, in addition to the Phibro proposal, the Standard Oil issue. This is done in Section VIII, where we also draw some conclusions on how the development of this kind of instrument may complement the NYMEX options or futures contracts. They represent the first step of a process that may ultimately provide the world petroleum market with instruments enabling participants to hedge against medium- and long-term price risks.
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