Managing Crude Oil Using Derivatives

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MANAGING CRUDE OIL USING DERIVATIVES

The present price markers for crude oil are WTI, Brent and Dubai/Oman. The crude oil derivatives contracts are traded on the New York Mercantile Exchange (NYMEX). The exchange acts as a regulatory body and as a financial trading forum for all the parties interested in buying the options. Members of the exchange carry out the trades themselves, or they act on behalf of the firms they represent through an open outcry auction held in the trading room or the floor. The procedure begins when a buyer calls an authorized commodity broker with an order to buy or sell futures or options contract. This order is sent to the firm’s agent who is on the trading floor. The prospects of more profits increases for the
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If the price of oil is tripled in a year then the company is able to purchase oil at the last years “locked in” price, which is lower than the current price, which in turn helps the company to save a lot of money (Grabianowski, 2009). But, if the price of oil falls then the company ends up paying more and loses money.

There are different types of financial instruments available for companies and investors to hedge against crude oil price volatility. These instruments can be traded financially without the tangible physical delivery of crude oil and different instruments have different time periods. Some of the hedging tools are Options, Futures and Swaps. But for this paper we will only focus on option contracts for management of risk in crude oil trading.

OPTIONS

The modern-day financial options market came into existence in 1973. It was known as the Chicago Board Options Exchange. During the same year, Fisher Black and Myron Scholes invented a formula to calculate the price of an option using specific variables. This formula was later called the Black Scholes Pricing Model and it had a huge impact on investors as they became confident about the idea of trading options. As of today there are thousands of option instruments (stocks, bonds and currency) listed in the market and millions of them are traded every day.

Options offer extra flexibility to buyers for managing currency or price risk as they work like an insurance policy. Call option and Put option
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