Structured Products Overview (OTC trading or over-the-counter trading)

Investment markets contain inherent risks and should be evaluated carefully prior to execution. Past performance is not necissarily indactive of future results.

TABLE OF CONTENTS - Click to Navigate to Desired Section

Why Use Structured Products? One of the many uses of OTC structured products is to make discount purchases or premium sales relative to a specific futures contract. Exchange traded options may be combined to create such a price improvement, but OTC structures allow for the price improvement to be considerably larger. Two features of OTC structures that make this possible are: 1) OTC options such as barrier or digital options have payout and risk profiles which may provide for strike improvement due to variations in their payouts, and 2) building strips of such options may further enhance price improvement while also providing interim accumulation of positions.

OTC structured products are also useful for obtaining liquidity in commodities with a limited exchangetraded presence. Often, buyers and sellers may be matched up with offsetting OTC swaps even where exchange volume is low or nonexistent.

Back to Top

Risks: OTC structured products have their own set of risks that should be carefully understood prior to execution. Many structures utilize exotic options that provide various benefits, but at the expense of new risks. Throughout the structure descriptions below, we explain the options used to build each structure, and point out risks specific to each structure type. Our job on the OTC Desk is risk management, and we emphasize risk discussions with all of our clients.

OTC trades are normally bilateral, meaning they are between two counterparties. Since these trades do not clear through a regulated exchange, OTC transactions bring counterparty risk into the equation. Counterparty risk includes credit risk associated with the creditworthiness of a trading counterparty, and legal risks when terms of a trade or the trading relationship itself aren’t explicitly defined beforehand.

Many OTC trades in the energy market are not considered bilateral. They clear through the CME’s ClearPort exchange, and are guaranteed by the CME. Corn, bean, and wheat calendar swaps are also standardized OTC trades that may be traded through the regulated ClearPort exchange. This Product Overview focuses exclusively on bilateral, non-exchange traded OTC products.

In general, OTC structured products are an additional tool in the risk management toolbox. They provide customized solutions to risk management and budgeting issues, and are useful in creating strategies that can’t be duplicated with exchange-traded derivatives.

Back to Top

BTR’s OTC Team
The BTR OTC team consists of trading and risk management professionals tasked with designing OTC hedging solutions. The OTC Desk exists to help clients identify and create suitable OTC hedging tools. Structured products are designed, created, and managed dynamically by the desk, which is considered a “matched principal” desk, relying on a combination of global counterparties and exchangetraded hedges to manage exposures produced by its structuring activity.

Back to Top

Trading OTC Structured Products with BTR Trading Group
Prospective OTC clients are encouraged to spend time discussing their needs and objectives with the OTC desk prior to engaging in OTC structured transactions. Once a decision is made to proceed, the OTC Desk will work in conjunction with the client’s sales professional to gather the required financial and compliance documentation needed for OTC trading approval.

Back to Top

The OTC Agreement
As part of the process of establishing an OTC trading relationship with BTR Trading Group, a client will execute a bilateral agreement with BTR Trading Group or one of its subsidiaries (an “OTC Agreement”). OTC trades are not typically subject to the rules and regulations applicable to exchange-traded products, and thus require different documentation. BTR Trading Group uses two types of OTC transactional agreements: a Master Swap Agreement and an ISDA Master Agreement. The Master Swap Agreement is typically used for US counterparties, while The ISDA Master Agreement is a more comprehensive agreement published by the International Swaps and Derivatives Association and is more suitable for clients requiring special terms in their agreement and for non-US domiciled counterparties.

Once the appropriate paperwork has been signed and returned, a client may begin transacting in the OTC markets with BTR Trading Group.

Back to Top

OTC Position Statements and Trade Confirmations
The OTC desk provides a “Trade Recap” for each trade a client executes. The Trade Recap summarizes trade details and is sent out shortly after the trade is executed. It is useful for quickly checking the terms of a trade.

BTR’s Operations department records OTC trades and sends out an official “Trade Confirmation” for each trade. A client is responsible for signing and returning official Trade Confirmations. The Operations department also provides a daily statement showing positions and balances. The Operations department works in conjunction with Margin and Risk to ensure collateral balances and position risk parameters are within set thresholds.

Back to Top

Finding the Right Structures
In our experience, clients tend to identify a short list of specific trade structures that best fit their needs, and those structures quickly become favorites in their risk management toolboxes. Occasionally, a client will suggest modifications to a structure to fit specific needs. The BTR OTC Desk works in conjunction with clients to evaluate and incorporate requested modifications, along with an in-depth evaluation of the risks and payouts which may accompany any modifications In all cases, OTC structures may be modified in real-time prior to execution. We are often asked to solve for several variables in a structure while holding one or more variables constant. Trade size is also not an issue. No trade is too small, and large trades are subject to our ability to operate discreetly on a client’s behalf.

Back to Top

Options used in OTC Structures
Most exchange-listed options are considered “American” options. The American designation simply means the option may be exercised prior to its expiration date. With options on futures contracts, there is no quantitative benefit to an early-exercise feature. “European” options do not have an early exercise feature, and thus tend to be slightly less expensive than their American counterparts. They may be exercised at expiration only. The American/European designation is used strictly to clarify an option’s
exercise feature, and the OTC structuring community uses European options extensively when building structures.

The payoff of an option may be tailored to fit certain conditions, with each style of payoff being categorized with its own naming convention.

Barrier options are designed with a “knock” barrier that causes the option to either be knocked into existence or knocked out of existence upon reaching a predefined barrier level. From a price perspective, options with barriers tend to be less expensive than those without. The reduced price, however, comes with the increased risk of reaching the barrier and having a payout and hedge profile considerably different from that of an exchange-traded option.

Digital options have an explicit, static, predefined payoff if the option expires in-the-money. Digitals are also typically less expensive than exchange-traded options, with a risk that the static payoff profile does not match the actual movement of the underlying commodity. For example, a digital option with a $200 payout will provide the owner with exactly $200 in proceeds if the option expires in-the-money by any amount. Digital options are commonly referred to as binary options or fixed payout options. It is also possible to design digital options with a barrier to create digital barrier options.

Asian options come in several configurations. The most common have a payoff dependent on the average price of the underlying over a specific period of time. As with digital options, the primary risk is that the average used to calculate their payoff is different from the final difference between the underlying commodity’s settlement price and the option’s strike price. Look-back options allow one to lock in the highest or lowest price over some time period as the option’s strike. Look-backs tend to be considerably more expensive than any other type of option, and are similar in utility to the purchase (or sale) of both a call and a put at the same strike.

Many more option varieties exist, but those mentioned above have proved particularly useful when building OTC structures. Below, we describe a few OTC structured products using OTC options, and compare their benefits and risks.

Back to Top

How This Document is Organized
To build a template for comparing several OTC structures, we start by trying to accomplish a specific goal using exchange-traded options. We then move to OTC structures to accomplish the same objective, comparing the differences in risks and payoffs. We begin by creating a generic commodity with a current price of 100 so that the reader may calculate percentages between strikes and spot levels more easily. For swaps that include barriers, we’ve used the same barrier level throughout so that quick comparisons across the various swaps may be easily performed. All products were evaluated using a time-to-expiration of approximately six months. For structures with longer-dated expirations, a general rule of thumb is that all buying levels will be lower and all selling levels will be higher holding everything else constant.

In the following pages, after defining an exchange-traded strategy, we examine and compare structures that knock out and structures that provided protection on predefined quantities. This distinction; knockout trades versus predefined quantity trades, is important. In many cases a hedger may be willing to improve a purchase or sales level by assuming the added risk of potential knock out. In other cases, the hedger will be most interested in protecting a predetermined quantity, and will not be interested in any swap that might knock out.

Back to Top

Products for Commodity Consumers

Exchange Traded Options as a Benchmark
Scenario: With 6-month futures trading 100, a hedger wants to use exchange-traded options to make below-market purchases, and with a net zero premium for the options.

Strategy: The hedger wants to build an option position resulting in zero upfront premium along with a discount purchase level. A typical zero-cost collar would require buying an out-of-the-money call along with selling an out-of-the-money put. This can solve the zero-cost problem, but does not address the task of making a discount purchase.

To make a discount purchase, the hedger would need to identify a below-market strike for a call purchase, and the trade would require selling more than one put on the same strike (to keep the trade at zero-cost).

Results: By purchasing one 92 strike call (at 12) along with selling two 92 strike puts (at 6 each), the hedger creates a zero-cost structure allowing the trade at expiration to provide a 92 purchase level. If futures settle above 92, the long 92 strike call is exercised. If the futures settle below 92, the call expires worthless, but the two short puts are assigned to the seller, resulting in the purchase of two lots at 92. This extra short put acts to bring the total option premium down to zero, but at the risk of causing an additional quantity purchase down at 92 if the futures settle below that level at expiration (or if exercised early). This extra quantity risk is referred to in the OTC community as “double-up” risk.

Risk: The sale of two puts causes this trade to be at risk of “double-up” if the futures settle below 92 at expiration. A double-up is when the preferred hedge quantity (one lot in this case) is doubled due the trade being structured with two times more short puts than long calls.

Back to Top

Consumer Swaps that “Knock Out”

The Synthetic Hedge to Arrive using OTC Barrier Options (“Synthetic HTA”)
Scenario: The hedger would like a deeper discount purchase level than that provided by the exchange traded option strategy, but is concerned about the double up risk if futures settle below the strike. The hedger also maintains a market opinion that the futures currently trading 100 have a low probability of reaching 120 before expiration.

Strategy: By replacing the exchange traded options with OTC Barrier options that cease to exist if the futures trade up to 120, the strike for a zero-cost structure is 83. The hedger buys one 83 strike call and sells one 83 strike put. These options have a knock-out feature which causes the options to terminate early with no payout if the futures trade up to 120. The purchase level is improved at the expense of not being hedged if the futures trade up to 120.

Because the options contain a 120 barrier, the 83 call is much cheaper than its exchange equivalent (if there were an 83 strike exchange-traded option). The barrier put is almost identically priced to its hypothetical exchange-equivalent. Thus, rather than having to sell two puts to take the net premium down to zero, only one put must be sold. The “double-up” risk has been alleviated, but a new upside knock-out risk has been added.

Result: At expiration, the hedger will now make an 83 purchase, but only if the futures have not traded up to 120 between trade date and expiration date. If the hedger wants to lower the risk of knocking out, the hedge could beconstructed using a higher knock-out barrier. For example, a 128 knock provides an 86 purchase level. A 137 knock provides an 89 purchase level.

Risk: During the swap’s lifetime, if the underlying futures trade up to 120, the swap is terminated, and the client no longer has a hedge in place. This risk is considerable, particularly if the futures continue trading higher due to a supply disruption.

Additional Notes: The Synthetic HTA consists of one-time, expiration-only options which are subject topre-expiration knock-out. The OTC Desk can substitute strips of options in place of the one-time options at the client’s request. Doing so brings the discount purchase level closer to spot prices, but it also allows for daily accumulations until expiration or a knock event. This “accumulating Synthetic HTA” provides at least some amount of daily quantity purchases before being knocked out – unless knock-out occurs on day one. With an accumulating Synthetic HTA, the client keeps all daily purchases that occur prior to a knock event.

Back to Top

Discount Purchase Swap with a potential Daily Double (“DPS-KO Daily Double”)
Scenario: Futures trading 100, hedger wants below-market purchases. Hedger is concerned about an upside move, and would like to make incremental purchases prior to any knock out. Hedger also has a concern about an eventual move down, and wants double-up risk to diminish with time. Hedger feels that reaching the 120 level is still a low probability event.

Strategy: A DPS-KO Daily Double swap is priced with daily strips of barrier options to accomplish its task. The structure is built with a daily strip of 88 calls, and two daily strips of 88 puts. All of the options are built with a 120 knock-out level. Trade price is zero-premium. A client’s total quantity is divided by the number of trading days, with an equal daily quantity being priced each day the swap is active. The double-up risk expires a little each day. If futures trade up to 120, the client keeps any previously priced bushels, and the swap, along with the remaining daily double up obligations, are terminated early.

Result: 88 daily purchase level (subject to 120 knock out). Hedger makes daily purchases at 88 until expiration or until futures trade 120. On any day the futures settle below 88, client makes an additional daily quantity purchase at 88.

Upside Risk: During the swap’s lifetime, if the underlying futures trade up to 120, the swap is terminated, and the client no longer has a hedge in place. The client will keep any daily purchases made prior to the knock event.

Downside Risk: On any day the futures settle below 88, the client will make the daily quantity purchase at 88 for two daily quantities. If the futures settle below 88 on every day of the swap’s lifetime, and the swap never experiences a barrier event, the client will buy a total of 2x the swap quantity at a price of 88 by the
expiration date of the swap.

Back to Top

Discount Purchase Swap with a potential one-time Euro Double (“DPS-KO Euro Double”)
Scenario: Hedger is willing to build the hedge with a one-time, expiration-only double up rather than the strip of daily double ups.

Strategy: Similar to the DPS-KO daily double, this trade makes daily purchases until expiration or 120 knock out. Unlike the daily double, the entire double up risk is concentrated at the end.

Result: An 86 daily purchase level (subject to 120 knock out). Make daily purchases at 86 until expiration or until futures trade 120.

Risks: Upside Risk: If the underlying futures trade up to 120, the swap and the potential double-up are terminated early. The client will keep any purchase made prior to the knock event, but will be left unhedged on any remaining daily purchases.

Downside Risk: The potential double up is concentrated all at the end unless the swap has knocked out first. If no knock out, and if the futures settle below 86 on expiration date, the client will make an additional full-quantity purchase at 86.

Back to Top

Discount Purchase Swap with a “Ratchet Euro Double” (“DPS-Ratchet”)
Scenario: Hedger wants a DPS-KO type structure, but with a double up purchase obligation that ratchets down to a lower strike if futures fall significantly.

Strategy: The DPS-Ratchet is similar to the DPS-KO Euro Double, except that the one-time double up has a downward strike shift built into it, and the potential double up does not cease to exist if the futures trade up to 120.

Result: An 87 daily purchase level (subject to 120 knock out of the daily accumulation). Make daily purchases at 87 until expiration or until futures trade at 120. The potential double up is concentrated all at the end, and it remains in effect even if the accumulation swap has been knocked out. The potential double up is initially set at 87, but if futures trade down to 60, the double-up strike is ratcheted down to 77. The double up is only a purchase obligation if the futures settle below the double up strike in effect at expiration.

Upside Risk: If the underlying futures trade up to 120, the daily accumulation swap is terminated early. The client will keep any purchase made prior to the knock event, but will be left un-hedged on any remaining daily purchases. Another upside risk is that the potential double-up remains in effect even if the futures trade 120.

Downside Risk: The potential double up is concentrated all at the end . If the futures settle below 87 on expiration date, the client will make an additional full-quantity purchase at 87 (The 87 level will be ratcheted down to 77 if the futures fall to 68 during the swap’s lifetime.

Back to Top

Discount Purchase Swap with a Conditional Euro Double (“DPS-Conditional”)
Scenario: Hedger wants a DPS-KO type structure. The double up should be designed with a knock in feature so that even though it is a potential purchase obligation, the purchase obligation is only in effect if in-the-money at expiration, and only if the futures have experienced a predefined downside move to activate the obligation.

Strategy: The DPS-Conditional has it’s double up obligation structured as a knock-in option with a knock-in barrier well below the market. Thus, even if the double up is in-the-money at expiration, it results in an additional purchase only if it has previously been knocked into existence.

Result: An 86 daily purchase level (subject to 120 knock out of the daily accumulation). Make daily purchases at 86 until expiration or until futures trade at 120. The potential double up is concentrated all at the end, and is set at 86. but for the double up to be effective, futures must trade down to 68 at some point between the start date and the expiration date. The 68 level “knocks in” the double up obligation. Once knocked in, if the futures settle below 86 on expiration date, the hedger will make an additional purchase at 86. If the futures never trade down to 68, the double-up will not result in an additional purchase regardless of final settlement (above 68).

Upside Risk: If the underlying futures trade up to 120, the daily accumulation swap is terminated early. The client will keep any purchase made prior to the knock event, but will be left un-hedged on any remaining daily purchases. The upside 120 knock-out level does not terminate the potential double-up.

Downside Risk: The potential double up is concentrated all at the end. If the futures settle below 86 on expiration date, the client will make an additional full-quantity purchase at 86, but only if the futures have traded down to 68 during the lifetime of the swap.

Back to Top

DPS-KO Ladder
Scenario: Futures trading 100, hedger wants at-the-money protection with incremental discount purchases, and is willing to accept the risk of a knock out on the upside in exchange for deeper discount purchase steps.

Strategy: The DPS-KO Ladder sets an at-the-money protection level by using a strip of calls. Digital puts with payouts of 9 are used to create steps. The trade comes with an expiration-only double-up aligned with the lowest step.

Result: Make daily purchases no higher than 100 until the earlier of expiration or until futures trade 120. Prior to a 120 knock event, if futures settle below 100, make daily purchase at 91. If futures settle below 91, make daily purchase at 82. The DPS-KO Ladder comes with an expiration-only double-up at 82.

Risks: Upside is capped at 100, but only until the futures trade 120. Once futures trade 120, the trade is terminated early with no additional purchases. Daily purchases will be made at 82 even if the futures settle below 82, and the client is subject to an expiration-only double-up at 82 if futures settle below 82 at expiration and have not experienced a 120 knock event.

Back to Top

Consumer Swaps with Purchase Protection on a Defined Quantity
Often, a hedger will be sufficiently concerned about a large upside move to prefer an OTC structure that absolutely hedges the purchase of a predefined quantity. The OTC structure may include a double-up feature, but of primary importance is the hedge on a certain minimum quantity. For such structures, the discount purchase level tends to suffer in exchange for upside protection.

Discount Purchase Swap Either/Or (“DPS-EO”)
Scenario: Futures trading 100, hedger wants below-market purchases, but also wants protection on the upside. The hedger does not want the potential of being knocked out. Total quantity protection is of utmost importance.

Strategy: The DPS-EO starts with a discount purchase level and at-the-money protection on anything not purchased at the discount level. The structure is built with knock-out options at the discount level, and knock-in options at the protection level. All options share the same knock level (120 in this example).

Purchases are made each day at the discount purchase level until expiration or until the futures trade 120. If 120 trades, all residual purchases are automatically filled at the protection level. The trade comes with a one-time, expiration-only double-up at the discount purchase level, but this potential double-up is terminated if the futures trade 120.

Result: A 92 daily purchase level with an expiration-only double up also at 92. This structure will price daily at 92 until the futures trade up to 120 or until expiration. If the futures trade 120, any remaining daily purchases are filled instantly at the 100 protection level, and the trade is terminated early. At that point, the potential double up is also canceled with no further obligation.

Risks:  Upside risk is capped at 100.  Downside double‐up at 92 on expiration date, but only if futures have not traded 120.

Back to Top

Protected Max Averaging Swap (“PMax”)
Scenario: Futures trading 100, hedger wants at-the-money protection, and wants to participate in downside moves by making purchases at the lower prices.

Strategy: The PMax sets an at-the-money protection level by using a strip of calls. These calls are financed by selling a lower-strike strip of puts. An expiration-only double up also struck at the lower strike is included (this double-up may be replaced with a daily strip depending on the hedger’s preference). All the options involved in this structure are European exercise, plain vanilla options.

Result: Make daily purchases at the daily futures settlement, subject to upper and lower boundaries. The upper boundary is set at-the-money (100), and the lower boundary is set at 88. If futures settle above 100, that day’s purchase will be made at 100. If futures settle below 88, that day’s purchase will be made at 88. Settlements between the boundaries result in a daily purchase at the settlement price. The swap includes a double up obligation down at 88 on the expiration day. At expiration, if futures settle below 88, the hedger makes a separate purchase of the full quantity at 88.

Risks: Upside risk is capped at 100. Downside double-up at 88.

Additional Notes: The closest exchange-traded equivalent to a PMax would be to buy an at-the-money call, and find the put strike below where two puts could be sold to create a zero-premium trade. The PMax may be designed with a below-market protection level making it perform as a discount purchase swap.

Back to Top

DPS-Ladder
Scenario: Futures trading 100, hedger wants at-the-money protection with incremental discount purchases.

Strategy: The DPS-Ladder sets an at-the-money protection level by using a strip of calls. Digital puts with payouts of 5 are used to create steps. The trade comes with an expiration-only double-up aligned with the lowest step.

Result: Make daily purchases no higher than 100 in all cases. If futures settle below 100, make daily purchase at 95. If futures settle below 95, make daily purchase at 90. The Two-Stepper comes with an expiration-only double-up at 90.

Additional Notes: Ladder-type structures may include numerous rungs or steps, depending on client preferences. Double-ups may be structured as a one-time expiration-only or as a daily strip.

Risks: Upside risk is capped at 100. Downside double-up at 90.

Back to Top

Products for Commodity Producers

Exchange Traded Options as a Benchmark
Scenario: With 6-month futures trading 100, a hedger wants to use exchange-traded options to make above-market sales, and with a net zero premium for the options.

Strategy: The hedger wants to build an option position resulting in zero upfront option premium along with an above-market sales level. A typical zero-cost collar would require buying an out-of-the-money put along with selling an out-of-the-money call. This can solve the zero-cost problem, but does not address the task of making an above-market sale.

To make an above-market sale, the hedger would need to identify an above-market strike for a put purchase, and the trade would require selling more than one call on the same strike (to keep the trade at zero-cost).

By purchasing one 109 strike put (at 12) along with selling two 109 strike calls (at 6 each), the hedger creates a zero-cost structure allowing the trade at expiration to provide a 109 sales level. If futures settle below 109, the long 109 strike put is exercised. If the futures settle above 109, the put expires worthless, but the two short calls are assigned to the seller, resulting in the sale of two lots at 109. In OTC language, the second short call is generally referred to as a “double-up”. Although used to neutralize net option premium (and up-front cost of a trade), this extra short option presents a risk in the form of a potential sales obligation at the strike.

Result: A 109 sales level, but with a potential “double-up” at that level if futures settle above 109 on expiration day.

Back to Top

Producer Swaps that “Knock Out”

The Synthetic Hedge to Arrive using OTC Barrier Options (“Synthetic HTA”)
Scenario: The hedger would like a higher premium sales level than that provided by the exchange traded option strategy, but is concerned about the double up risk if futures settle above the strike. The hedger also maintains a market opinion that the futures currently trading 100 have a low probability of falling to 77 before expiration.

Strategy: By replacing the exchange traded options with OTC Barrier options that cease to exist if the futures trade down to 77, the strike for a zero-cost structure is 118. The hedger buys one 118 strike put and sells one 118 strike call. These options have a knock-out feature which causes the options to terminate early with no payout if the futures trade down to 77. The sales level is improved at the expense of not being hedged if the futures trade down to 77.

Because the options contain a 77 knock-out barrier, the 118 knock-out put is much cheaper than its exchange equivalent (if there were a 118 strike on the exchange for our hypothetical commodity). The barrier call is almost identically priced to its equivalent exchange listed calls (again, with the strike caveat). Thus, rather than having to sell two calls to take the net premium down to zero, only one call must be sold. The “double-up” risk has been alleviated, but a new downside knock-out risk has been added.

Result: At expiration, the hedger will now make a 118 sale, but only if the futures have between trade date and expiration date. If the hedger wants to lower the risk of knocking out, the hedge could be constructed using a lower knock-out barrier. For example, a 68 knock provides a 111 sales level. A 60 knock would provide a 106 sales level.

Risks: During the swap’s lifetime, if the futures trade down to 77, the Synthetic HTA is terminated early with no resulting sales. The client’s hedge no longer exists.

Additional Notes: The Synthetic HTA consists of one-time, expiration-only options which are subject to pre-expiration knock-out. The OTC Desk can substitute strips of options in place of the one-time options at the client’s request. Doing so brings the premium sales level closer to spot prices, but it also allows for daily accumulations until a knock event.

Back to Top

Premium Sales Swap with a potential Daily Double (“PSS-KO Daily Double”)
Scenario: Futures trading 100, hedger wants above-market sales. Hedger is concerned about a downside move, and would like to make incremental sales prior to any knock out. Hedger also has a concern about an eventual move up, and wants double-up risk to diminish with time. Hedger feels that reaching the 77 level is still a low probability event.

Strategy: A PSS-KO Daily Double swap is priced with daily strips of barrier options to accomplish its task. The structure is built with a daily strip of 110 puts, and two daily strips of 110 calls. All of the options are built with a 77 knock-out level. Trade price is zero-premium. A client’s total quantity is divided by the number of trading days, with an equal daily quantity being priced each day the swap is active. The double-up risk expires a little each day. If futures trade down to 77, the client keeps any previously priced bushels, and the swap, along with the daily double-ups, are terminated early. The strategy has downside knock-out risk due to the 77 knock out barrier, and double-up risk due to the potential to make a 2x daily quantity sale on each day futures settle above 110.

Result: A 110 daily sales level (subject to 77 knock out). Hedger makes daily sales at 110 until expiration or until futures trade 77. On any day the futures settle above 110, client makes an additional daily quantity sale at 110.

Upside Risk: On any day the futures settle above 110, the client will make the daily sale at 110 for two daily quantities. If the futures settle above 110 on every day of the swap’s lifetime, and the swap never experiences a barrier event, the client will sell a total of 2x the swap quantity at a price of 110 by the expiration date of the swap.

Downside Risk: During the swap’s lifetime, if the underlying futures trade down to 77, the swap is terminated, and the client no longer has a hedge in place. The client will keep any daily sales made prior to the knock event.

Back to Top

Premium Sales Swap with a potential one-time Euro Double (“PSS-KO Euro Double”)
Scenario: Hedger is willing to build the hedge with a one-time, expiration-only double up rather than the strip of daily double ups. This substitution will provide a higher sales level in exchange for a one-time,
expiration-only concentration of double-up risk.

Strategy: Similar to the PSS-KO daily double, this trade makes daily sales until expiration or 77 knock out. Unlike the daily double, the entire double up risk is concentrated at the end.

Result: A 114 daily sales level (subject to 77 knock out). Make daily sales at 114 until expiration or until futures trade 77. The potential double up is concentrated all at the end unless the swap has knocked out first. If no knock out, and if the futures settle babove 114 on expiration date, the client will make an additional full-quantity sale at 114. Compared to the “daily double” version of this swap, the daily selling level is increased at the expense of a one-time potential double up on expiration day. If the futures trade down to 77, both the swap and its potential double-up are terminated early.

Upside Risk: The client will make a daily sale at 114 even if the futures settle higher than 114. At expiration, if the futures settle above 114 the client will make an additional full-quantity sale at 114.

Downside Risk: During the swap’s lifetime, if the underlying futures trade down to 77, the swap is terminated, and the client no longer has a hedge in place. The client will keep any 114 level daily sales made prior to the knock event.

Back to Top

Premium Sales Swap with a “Ratchet Euro Double” (“PSS-Ratchet”)
Scenario: Hedger wants a PSS-KO type structure, but with a double up sales obligation that ratchets up to a higher strike if futures rise significantly.

Strategy: The PSS-Ratchet is built similarly to the PSS-KO Euro Double, except that the one-time double up has an upward strike shift built into it if futures trade up to a predetermined level. The upward shift or “ratchet” doesn’t alleviate the double-up risk, but it does raise the level. This beneficial ratchet buffer is at the expense of having a double-up that doesn’t terminate early with the swap if the futures trade down to the lower knock-out level.

Result: A 112 daily sales level (subject to 77 knock out of the daily accumulation). Make daily sales at 112 until expiration or until futures trade 77. The potential double up is concentrated all at the end, and it remains in effect even if the accumulation swap has been knocked out. The potential double up is initially set at 112, but if futures trade up to 120 (the ratchet level), the double-up strike is ratcheted up to 120. The double up is only a sales obligation if the futures settle above the double up strike in effect at expiration.

Upside Risk: The client will make a daily sale at 112 even if the futures settle higher than 112. At expiration, if the futures settle above 112 the client will make an additional full-quantity sale at 112. However, if the futures have traded up to 120, the additional full-quantity sale will be made at 120 instead of 112, and only if the futures settle above 120 on the expiration date.

Downside Risk: During the swap’s lifetime, if the underlying futures trade down to 77, the swap is terminated, and the client no longer has a hedge in place. The client will keep any 112 level daily sales made prior to the knock event. Although the swap may be terminated, the potential double-up remains in effect until the final expiration date which could result in a full-quantity sale at either 112 or 120 depending on the double-up strike in effect at expiration.

Back to Top

Premium Sales Swap with a Conditional Euro Double (“PSS-Conditional”)
Scenario: Hedger wants a PSS-KO type structure. The double up should be designed with a knock in feature so that even though it is a potential sales obligation, the sales obligation is only in effect if in-themoney at expiration, and only if the futures have experienced a significant upside move to activate the obligation.

Strategy: The PSS-Conditional has it’s double up obligation structured as a knock in option with a knock in barrier well above the market. Thus, even if the double up is in-the-money at expiration, it results in an additional sale only if it has previously been knocked into existence.

Result: A 114 daily sales level (subject to 77 knock out of the daily accumulation). Make daily sales at 114 until expiration or until futures trade 77. The potential double up is concentrated all at the end, and is set at 114. but for the double up to be effective, futures must trade up to 128 at some point between the start date and the expiration date. The 128 level “knocks in” the doubleup obligation. Once knocked in, if the futures settle above 114 on expiration date, the hedger will make an additional sale at 114. If futures never trade 128, the double-up is not exercisable even if futures settle above 114.

Upside Risk: The client will make a daily sale at 114 even if the futures settle higher than 114. At expiration, if the futures settle above 114 the client will make an additional full-quantity sale at 114, but only if the futures have traded at or above 128 during the lifetime of the swap.

Downside Risk: During the swap’s lifetime, if the underlying futures trade down to 77, the swap is terminated, and the client no longer has a hedge in place. The client will keep any 114 level daily sales made prior to the knock event. Although the swap may be terminated, the potential double-up remains in effect until the final expiration date which could result in a full-quantity sale at 114 if the futures trade at or above 128 during the lifetime of the swap.

Back to Top

PSS-KO Ladder
Scenario: Futures trading 100, hedger wants at-the-money protection, and expects a choppy market. Client wants the additional upside selling levels offered by assuming the risk of a 77 level knock-out.

Strategy: The PSS-KO Ladder is similar to a regular PSS-Ladder. However, by designing all legs of the trade with a lower knock-out barrier, higher selling levels are obtainable. The PSS-KO Ladder sets an atthe-money protection level by using a strip of puts. Digital calls with payouts of 13 are used to create steps. The trade comes with an expiration-only double-up aligned with the highest step, and this doubleup obligation is the predominant risk of the trade.

Result: The swap is built with a 77 level barrier. If futures trade down to 77, the client keeps all sales made prior to the barrier event, and the entire trade is terminated early. Until the futures trade 77, make daily sales no lower than 100. If futures settle above 100, make daily sale at 113. If futures settle above 113, make daily sale at 126. The PSS-KO Ladder comes with an expiration-only double-up at 126.

Risks: The trade may be terminated early if the futures ever trade down to 77. If knocked out, the client keeps all sales made prior to the knock event, but the client will be un-hedged on any remaining sales. Settlements above 126 result in sales at 126. A full-quantity potential double-up exists at 126. If futures settle above 126 at expiration, and the swap has not experienced a knock event, the client will make an additional full-quantity sale at 126.

Back to Top

Producer Swaps with Sales Protection on a Defined Quantity
Often, a hedger will be sufficiently concerned about a large downside move to prefer an OTC structure that absolutely hedges the sale of a predefined quantity. The OTC structure may include a double-up feature, but of primary importance is the hedge on a certain quantity. For such structures, the premium sales level tends to suffer in exchange for downside protection.

Premium Sales Swap Either/Or (“PSS-EO”)
Scenario: Futures trading 100, hedger wants above-market sales, but also wants protection on the downside. The hedger does not want the potential of being knocked out. Total quantity protection is of utmost importance. Strategy: The PSS-EO starts with a premium sales level on daily sales and at-the-money protection on anything not sold at the premium sales level. The structure is built with knock out options at the premium sales level, and knock in options at the protection level. All options share the same knock level (77 in this example). Sales are made each day at the premium sales level until expiration or until the futures trade
77. If 77 trades, all residual sales are automatically filled at the protection level. The trade comes with a one-time, expiration-only double-up at the premium sales level, but this double-up obligation is terminated if the futures trade down to 77 during the swap lifetime.

Result: A 109 daily sales level with an expiration-only double up also at 109. This structure will price daily at 109 until the futures trade down to 77. If the futures trade 77, any remaining daily sales are filled instantly at the 100 protection level, and the trade is terminated early. At that point, the potential double up is also canceled with no further obligation.

Upside Risk: The client will make a daily sale at 109 even if the futures settle higher than 109. At expiration, if the futures settle above 109 the client will make an additional full-quantity sale at 109, but this potential sales obligation ceases to exist if the futures traded at or below 77 during the lifetime of the swap.

Downside Risk: Downside risk is limited to the 100 strike protection level. Any quantity not sold at 109 gets sold instantly at 100 if the futures trade down to 77.

Back to Top

Protected Min Averaging Swap (“PMin”)
Scenario: Futures trading 100, hedger wants at-the-money protection, and wants to participate in upside moves by making sales at the higher settlement prices.

Strategy: The PMin sets an at-the-money protection level by using a strip of puts. These puts are financed in part by selling a higher-strike strip of calls. An expiration-only double up also struck at the higher strike is included (this double-up may be replaced with a daily strip depending on the hedger’s preference). All the options involved in this structure are European exercise, plain vanilla options.

Result: Make daily sales at the futures settlement, subject to upper and lower boundaries. The lower boundary is set at-the-money (100), and the upper boundary is set at 118. If futures settle below 100, that day’s sale will be made at 100. If futures settle above 118, that day’s sale will be made at 118.

Settlements between the boundaries result in a sale at that day’s settlement price. The swap includes a double up obligation at 118 on the expiration day. At expiration, if futures settle above 118, the hedger makes a separate sale of the full quantity at 118.

Additional Notes: The closest exchange-traded equivalent to a PMax would be to buy an at-the-money put, and find the call strike above where two calls could be sold to create a zero-premium trade.

Upside Risk: Daily sales will never be higher than 118 even if the futures settle higher. At expiration, if the futures settle above 118 the client will make an additional full-quantity sale at 118.

Downside Risk: Downside risk is limited to the 100 strike protection level.

Back to Top

PSS-Ladder
Scenario: Futures trading 100, hedger wants at-the-money protection, and expects a choppy market.

Strategy: The PSS-Ladder sets an at-the-money protection level by using a strip of puts. Digital calls with payouts of 7 are used to create steps. The trade comes with an expiration-only double-up aligned with the highest step, and this double-up obligation is the predominant risk of the trade.

Result: Make daily sales no lower than 100 in all cases. If futures settle above 100, make daily sale at 107. If futures settle above 107, make daily sale at 114. The PSS-Ladder comes with an expiration-only double-up at 114.

Additional Notes: Ladder-type structures may include numerous rungs or steps, depending on client preferences. Double-ups may be structured as expiration-only or as daily strips.

Risks:  Downside is protected at 100.  Settlements above 114 result in sales at 114.  A full‐quantity potential double‐up exists at 114.  If futures settle above 114 at expiration, the client will make an additional full‐quantity sale at 114.

Back to Top

Contact us for more information.

Back to Top