Commodity OptionsDiscussion Paper

Prepared by Owen Kin, Markit5th June 2008

The purpose of this paper is to help the FpML Commodity Working Group work towards consensus on an initial FpML model for commodity options.

1Existing modelling approaches

The EFET eCM Trade Confirmation schema covers commodity options and as has been noted in the Swaps paper will have benefitted from user review. The modelling approach however, is significantly different from that of FpML and this paper references it primarily in an attempt to verify completeness.

Neither the Goldman Sachs commodities FpML proposal nor that of the previous group covered options, though there was a proposal from Reuters in 2002 that did. It is not clear how far the Reuters proposal was reviewed and given the time that has elapsed and the fact that new Commodity Definitions have since been published by ISDA, it will be considered in this paper only where other models do not appear to present sensible approaches.

This paper looks primarily to the existing Equity Options FpML schema for guidance on option structure as well as certain parts of the Interest Rates schema for date sequence representations. Note that the commodity underlyer is not covered since this has been the subject of a separate paper.

1.1FpML equityOption

The fpml-eqd schema represents an equity option using the equityOption element which contains three sequences – the first contains fundamental properties of the option such as underlyer and exercise choices, the second features and conditions specific to equities and the third predominantly economics of the option such as strike price and the number of options.

Figure 1 – equityOption sequence 1 (fundamentals)

Figure 2 – equityOption sequence 2 (equity features and conditions)

Figure 3 – equityOption sequence 3 (economics)

There are clearly a number of elements in the schema which are only relevant to equities or will need to be adapted for commodities. The schema also does not have inherent support for strips of options, which appear to be common in commodities, suggesting a relatively significant change to the structure may be needed.

1.2EFET eCM

The EFET eCM Trade Confirmation scheme contains the optional optionDetails element which in turn contains elements specific to options.

2Initial Questionsand Suggestions

2.1Caps and Floors vs. Strips of Options

As noted in the introduction to this paper, asian commodity options are frequently booked as strips and this concept is not supported by the FpML equity options schema. There appear to be a number of properties that can vary between the different options in the strip:

  • Notional quantity
  • Strike price

and of course dates relevant to the individual options (often referred to as Calculation Period within the context of a strip). This suggests that a mechanism would need to be introduced to allow these values to be specified for each Calculation Period.

QuestionDoes the group agree that strips of asian options should be explicitly supported by the schema (as opposed to single options being represented multiple times)? Given the apparent popularity of this kind of trade and the fact that key properties are common across the strip it would seemsensible.

2.2Parameterised Representation of Calculation Periods

In the same way as commodity swaps, strips of asian commodity options are often confirmed without reference to specific Calculation Period dates (other than the Effective and Termination dates). For example:

Calculation Period(s): Monthly, from and including March 1, 2008 to and including November 31, 2008

SuggestionIf the group decides that the schema should explicitly support strips of asian options, the schema should provide a structure for the parametric representation of the Calculation Periods and the ability for a Notional Quantity and Strike Price to be specified per Calculation Period with reference to this schedule.

3Detailed Analysis

3.3Option Type

  • EFET eCM:OptionsType
  • FpML:optionType

Both schemas allow the values Call and Put

QuestionEFET also supports capped calls and floored put options (ie a limit on the pay-off) using the CappedPrice and FlooredPrice elements respectively. Does the group think these would be required?

QuestionFpML allows Payer and Receiver (for swaptions), Forward and Straddle, should these be modelled initially?

3.4Option Style

  • EFET eCM:OptionStyle
  • FpML:equityAmericanExercise, equityEuropeanExercise, and feature/asian

FpML does not have an explicit representation of option style but this can be determined by the presence of either the equityAmericanExercise or equityEuropeanExercise element within equityExercise, the latter used in combination with feature/asian to indicate an Asian option.

QuestionThere does not appear to be a need for Bermudan options for commodities. Should support for these be built into the schema initially?

3.5Notional Quantity and Strike Price

  • EFET eCM:TotalVolumeTotalVolumeUnit

StrikePrice

  • FpML:optionEntitlementnumberOfOptions

strike

SuggestionRepresent Notional Quantity and Strike Price in such a way that they can be specified for every Calculation Period.

QuestionWhat is the purpose of the spotPrice element in the equities schema?

QuestionThe EquityStrike type in FpML supports percentage values for forward starting options where averaging in is applicable (see below). Does this occur for commodities?

3.6Pricing Dates

  • FpML:asian/averagingPeriodOut

QuestionDoes averaging in (the determination of the strike price based on an average of the Commodity Reference Price over some period) need to be supported?

SuggestionRepresent Pricing Dates in such a way that a rule can be specified to apply to all Calculation Periods or a list of dates can be specified for each Calculation Period.

3.7Number of Options

  • FpML:numberOfOptions

SuggestionFor commodities it appears as though the size of a trade is represented using the Notional Quantity rather than a number of options so this would not be required.

3.8Features

  • FpML:feature

QuestionBarrier/knock features do not appear to be commonly used for commodities, though support for them was added in the 2005 ISDA Commodity Definitions. Should we look to model these initially?

3.9Premium

  • EFET eCM:PremiumPayments
  • FpML:equityPremium

QuestionEFET allows a series of premium payments to be specified (for each Calculation Period?) Is this required?

QuestionIs premiumType (PrePaid, PostPaid, Variable, Fixed) required for forward starting commodity options?

QuestionCouldswapPremium andpercentageOfNotional apply to commodities?

3.10Exercise

  • EFET eCM:OptionDetails
  • FpML:equityExercise

QuestionAre prepayment features relevant to commodity options?

3.11Settlement

  • FpML:equityExercise

QuestionShould physical settlement or election of settlement method be supported?

SuggestionA similar method to that proposed for swap Payment Dates could be used to represent the Settlement Dates as an offset to the end of the Calculation Periods.

3.12Common Pricing

SuggestionAs per swaps, include as an optional element at the trade level.

ISDA Confirmation Cross Reference

This section refers to the terms in Exhibit II-B to the 2005 ISDA Commodity Definitions.

General Terms

Trade DatetradeHeader

Commodityunderlyer

Notional Quantity3.5Notional Quantity and Strike Price

Total Notional Quantity3.5Notional Quantity and Strike Price

Notional Quantity per Calculation Period3.5Notional Quantity and Strike Price

Option Style3.4Option Style

Option Type3.3Option Type

SellersellerPartyReference

BuyerbuyerPartyReference

Floating Priceunderlyer

Commodity Reference Priceunderlyer

Common Pricing3.12Common Pricing

Business Day?

Settlement PeriodsNot yet considered

Specified Priceunderlyer

Delivery Dateunderlyer

Pricing Date(s)3.6Pricing Dates

Method of Averaging3.6Pricing Dates

Currency Conversion ProvisionNot yet considered

Strike Price per Unit3.5Notional Quantity and Strike Price

Total Premium3.9Premium

Premium Payment Date(s)3.9Premium

Procedure for Exercise3.8Exercise

Exercise Period

Potential Exercise Dates

Expiration Date

Expiration Time

Automatic Exercise

Written Confirmation

Seller Business Day

Seller’s location…

Market DisruptionAs per swaps

Market Disruption Event(s)

Additional Market Disruption Event(s)

Disruption Fallback(s)

Fallback Reference Price

Maximum Days of Disruption

Cash Settlement Terms

Cash Settlement3.11Settlement

Settlement Date(s)3.11Settlement

Knock-in Provisions3.8Features

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