What Are Exotic Derivative Products?

Since the dawn of trade and exchange, people have been compelled to speculate upon the future value of nearly everything under the sun. Formulating an educated guess of what something will be worth next week, month or year remains one of mankind's favourite pastimes. The modern global derivatives market provides individuals an avenue by which to profit from successful prognostication.

Derivatives products based upon traditional underlying assets such as commodities, debt instruments or equities indices have been the focus of both hedging and speculative trading operations for decades. However, the popularity of more unconventional products has given rise to a wide variety of exotic futures and options contracts.

The standardised trade of derivatives have made the possibility of placing a wager on the future value of almost anything a reality. Speculation regarding the potential result of an upcoming event or series of events exists as both entertainment and big business.

Exotic Derivative Products: Why?

There are several reasons why an exchange will periodically launch an unconventional futures or options contract. Often, the media "buzz" surrounding the launch of an exotic contract will bolster trading volumes, attract new customers and achieve product differentiation through generating public interest.

A noted example of this practice was the creation of the Domestic Box Office Receipt (DBOR) futures contract by the Cantor Exchange in 2010. In effect, this contract was to provide motion picture production companies with a method of hedging capital risk while allowing speculators to supply liquidity to the market through taking positions on potential box office returns. The contract was initially approved by the U.S. Commodity Futures Trading Commission (CFTC) on 28 June, 2010,^[1] but shortly thereafter the trade was banned by Congress.

The volumes that the DBOR contract could have generated remain unclear, as does its potential success or failure. However, the public interest and media attention created by Cantor's launch of the DBOR serves as a prime example of exactly why exchanges and markets around the world create and introduce unconventional contracts to the open market every year.

However, in the event that exotics such as DBOR are permitted to trade on the open market, the ultimate success of the contract is not ensured. Failure rates of new futures contracts are substantial, with a large number of them never gaining traction. A 2011 study released by the CME Group stated that 29.3% of all new futures contracts launched on the Chicago Mercantile Exchange (CME) between 1999 and 2010 failed to attract any interest or trading volume.^[2] A similar study of the broader futures market reported that 52% of all new contracts launched in the calendar year of 2011 failed to trade even once.^[2]

While the success of a new derivatives product is far from a foregone conclusion, academics and industry professionals alike have formally addressed the necessary ingredients vital to a product's advancement. According to professional opinion within the derivatives industry, there are several inputs crucial to the longevity and viability of a new product:

• Commercial demand for hedging: Large-scale producers and consumers must identify the need to mitigate risk associated with pricing volatility attributable to unknown circumstances.
• Attractive to speculators: Individuals interested in capitalising upon pricing volatility must participate in the contract's trade. Speculators provide the bulk of liquidity to the market thus ensuring an efficient process of price discovery.
• Cooperative public policy: Governments and regulatory bodies need to be receptive of the ideology on which the product is based. Regulatory cooperation ensures that the market will operate without interruption.^[3]

Although futures and options involving unconventional underlying asset classes may seem comical at first, many satisfy the prerequisites needed to thrive. The product has a chance for success as long as there are institutions with a need to mitigate risk, an interested group of investors and traders coupled with regulatory cooperation.

Weather Derivatives

The concept of trading weather derivatives in a standardised format dates to the mid-1990s and the deregulation of the U.S. energy industry. Shortly after passage of the Energy Policy Act of 1992 (EPACT),^[4] an abundance of independent energy producers identified a need to manage exposure to risks associated with unpredictable weather.

As demand for these types of hedging mechanisms grew, companies specialising in the trade of energy began to develop derivative products based upon the variance in weather patterns. In 1997, Aquila, Enron and Koch Industries conducted the first weather derivative transactions in a private over-the-counter (OTC) capacity.^[5] While the companies involved in this pioneering business venture ended up being controversial, the idea of trading weather-based derivative products grew in popularity.

In attempt to capitalise on the expanding public interest for products based on the weather, the CME Group officially launched a centralised weather futures exchange in 1999. Two standard futures contracts were offered, heating degree days (HDD) and cooling degree days (CDD). The contracts represented the aggregate difference from a base temperature of 65 degrees Fahrenheit for each day in a calendar month at a specific locale.^[6]

The first HDD and CDD contracts included offerings for ten U.S. cities, but as demand grew, the scope of offerings did as well. HDD and CDD futures and options offered by the CME Group grew to nearly 50 international cities with both monthly and seasonal products supported.^[6] The HDD and CDD contracts are available for trade on a monthly and seasonal basis, focussed on the weather cycles in numerous cities located in the U.S., U.K. and the Netherlands.

Products using precipitation levels as the underlying asset are another form of weather-related derivatives. Beginning in 2006, the CME Group commenced offering standardised snowfall contracts. The product was based on the aggregate seasonal snowfall, denominated in inches, for one of ten U.S. locales.^[7] Snowfall markets saw substantial participation soon after their launch as both public and private sector entities sought to limit exposure to abnormal snowfall levels. Ski resorts desired insurance from a lack of snow, while specific municipalities wanted to avoid fallout from extensive snow removal costs.

Inspired by the snowfall contract, products related to rainfall, frost and hurricanes were created and launched by the CME Group. However, the trade of precipitation derivatives has been largely eliminated, as the CME delisted the majority of these types of products in 2014 citing lack of volume and open interest.^[8] Today, the trade of precipitation-based futures and options exists as a more private venture, functioning in an OTC capacity.

Environmental Impact Derivatives

The rise in popularity of climate change ideology has led governing bodies to introduce legislation aimed at the reduction of greenhouse gasses. The European Union has been at the forefront of addressing climate change on a practical level. On 1 January, 2005, the EU emissions trading system (EU ETS) was introduced. It's the world's first and largest carbon market, stemming from ideals promoted in the Kyoto Protocol and existing as a global example for "cap and trade." The EU ETS limits emissions from industrial plants, power stations and airlines in all 28 EU countries as well as Iceland, Liechtenstein and Norway.^[9]

The promotion of "cap and trade" has created a new asset class known as emissions. Because emissions levels are monitored and quantified in many cities and countries around the globe, the trade of credits or allowances pertaining to emissions levels have grown in popularity. Shortly after the creation of the EU ETS, the Intercontinental Exchange (ICE), in concert with the European Climate Exchange (ECX), launched the ECX EUA futures contract. ECX EUA futures marked the commencement of the open trade of emissions on a centralised exchange.^[10]

The advent of emissions-based derivatives has given the EU ETS a method of facilitating the trade of emissions credits. Market participants are able to engage in hedging practices, take delivery of credits or speculate on the potential value of emissions in years to come.

ICE offers several emissions-based futures and option contracts, addressing the European market. In addition, ICE offers a variety of futures and options contracts pertaining to the United States. Products based upon greenhouse gasses, solar energy production and carbon credits for specific states are available for trade.

Electricity Derivatives

Access to electricity is a requirement for any substantial economic development, in addition to being a key aspect of our everyday lives. According to statistics provided by the World Bank, electricity is available and used by 84.58% of the world's population.^[11] China, the United States, Russia, Japan and India lead global consumption.

While the long-term demand for electricity is robust, several factors impact short-term pricing and have the potential to expose consumers and producers to considerable risk. Extreme weather variations, damage to electrical infrastructure, political upheaval, or a disruption in the supply of energy commodities may create unpredictable spikes in energy prices. In order to mitigate this risk, energy producers and large-scale consumers engage in hedging through electricity derivatives, while other market participants speculate on the fluctuations in price.

Exchange-based trading of electricity futures is available through a number of outlets. The CME Group, NASDAQ and ICE offer a wide variety of electricity products based upon price levels for different regions, durations and output.

Listed below are a few of the more commonly traded electricity futures contracts:

• CME Group: New England, Connecticut, PJM ComEd Zone 5 MW Peak.^[13]
• NASDAQ: Nordic, German, Dutch and U.K. power futures.^[14]
• ICE: Belgian and Dutch power baseload futures. German, Italian and French financial fixed settlement futures contracts.^[15]

Electricity futures typically trade with sporadic volumes, largely attributable to the needs of hedgers. Some contracts trade heavily on a periodic basis, while others experience long intervals between trades.

Summary

Aside from contracts based on weather, emissions or electricity, many derivative products are actively traded every day on the world's markets.

Here are a few of the more unique futures contracts regularly traded internationally:

• Diesel: South Africa, Johannesburg Stock Exchange
• Steel Rebar: China, Shanghai Futures Exchange
• Polyvinyl Chloride (PVC): India, Pragati ka Solid Exchange
• Lumber: United States, CME Globex
• Real Estate Indices: Europe and Asia, Eurex Exchange

Depending on one's business, exotic derivatives can be a useful tool for risk management. Also, they may afford speculators attractive avenues by which to profit from pricing volatilities facing the underlying assets.

However, traders and investors are well advised to perform the necessary due diligence before engaging these unconventional markets. Sporadic liquidity coupled with limited open interest can place inexperienced traders at a considerable disadvantage. Ultimately, it is up to the individual to decide whether or not the trade of exotic derivatives is a suitable endeavour given capital constraints and risk tolerance.

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