Editor’s Letter

SPECIAL ISSUE: DERIVATIVES IN ASSET MANAGEMENT!

Frank Fabozzi, editor of The Journal of Portfolio Management and a member of the Advisory Board of The Journal of Derivatives, and I are releasing imminently a special issue of practitioner articles in the realm of asset management. Our focus is educational—we expect the articles of our industry-expert authors to serve as valuable classroom material.

NEGATIVE OIL FUTURES PRICE IN APRIL 2020: A GREAT DERIVATIVES ERROR

I have an opinion to express. The negative oil futures price (close-to-expiry May contract for WTI crude oil) on April 20, 2020, denotes a “derivatives error” of huge proportion. Rather than being simply an extreme market event reflecting buying and selling interest, I call this a mistake of derivative construction. Just as civil engineers study bridge and other construction failures, it is important to discuss and dissect derivative failures.

Our first article in this Spring 2022 issue is “Negative WTI Price: What Really Happened and What Can We Learn?” Hence, I take the opportunity in this Letter to express my thoughts and judgments of this astounding derivative event (albeit almost two years after the fact). My opinions here are my own and are not those of the author of this captivating article, nor of the publisher or any other affiliate of mine.

Is it possible for a buyer and seller to agree to a negative price? Yes, it’s conceivable just as many hypothetical events are conceivable. I don’t believe anywhere in the world there occurred an actual arm’s length sale of physical oil at a negative price on or about April 20, 2020; but this assertion is not itself an argument.

The critically important principle to establish is that a properly constructed futures contract should enable a valid hedge for the contract participants be they producers, consumers, or speculators. The critically important observation is that the binding contract for payment and delivery of oil for futures participants at expiry does not, with high likelihood, interpret a “negative price” as being a payment from seller to buyer.¹ Most likely, the parties within or without litigation would treat “negative price” as “zero price.”²

Just as I wrote above my concurrence to the hypothetical possibility that buyer and seller might agree on a negative price for an asset, I provide below a hypothetical story that I consider much closer to reality.

A SHORT STORY OF FUTURES HEDGING

Market participant X expects to buy oil in roughly a month and seeks to hedge its price risk now by entering an appropriate (long) futures contract. Additionally, X plans to maintain this contract to expiration and then buy the oil under the Exchange’s physical delivery contract in which the purchase price is contractually the final futures price. X enters the contract at $20 per barrel. The basic purpose of the long futures position is that X has locked in this $20 price if it holds the contract to expiration (as X plans to do). That is, if the futures price falls to $15 by expiration, X will have paid away this loss of $5 to the Exchange, but its final oil purchase price is $15; hence the total cost to X is the desired $20. Conversely, if the futures price rises to $28 by expiration, X will have received $8 from the Exchange. With the final oil purchase price at this $28, X’s net cost per barrel of oil will be $20. That’s entirely and precisely how futures contracts work to lock in the price at which X initially enters.

But this hedging fails if the Exchange permits the futures price to go below zero because the physical delivery contract (likely and arguably) does not permit a negative price. That is, imagine the final futures price settles at negative $10. Then X will have paid $30 in futures losses. But the oil purchase price of the physical transaction at expiry will NOT be negative $10 (i.e., a payment from the seller to X of $10). If X would receive this $10 per barrel payment while also receiving oil delivery, then X’s hedge WOULD work since X’s net payment would be the initial $20. A court, arbitrator, or mediator may arrive at one of three conclusions regarding the contentious contract with negative final price. Either the contract is void, so that no exchange of money or oil occurs; or seller delivers oil, makes no payment to X and agrees to receive zero payment from X; or seller delivers oil and also makes the $10 “negative payment” to X. With the first two possibilities, the futures contract does not provide the correct hedge to X.

This case of X hedging its anticipated purchase of oil with oil futures contracts is the textbook explanation for what futures are and how they should work. Futures exist entirely for this purpose and they perform the same, mirror image, hedging function for any participant Y that anticipates selling oil at a known future time. It is irrelevant that any particular trader may not have intent to hold the futures contracts to final expiration and engage in taking or making delivery of physical oil. The futures contracts must work as advertised for hedging for all participants.

OUR NEW ARTICLES

Leading the six articles of this issue, Ma, of the University of Illinois at Chicago, dives into the details of the April 2020 negative WTI oil futures price. The negative oil price attracted huge attention from the financial and popular media at the time, as it should have. Our author takes a better look at proximate causes and the actions of the CME, retail investors, and speculators. Fascinating and not, in my view, a coincidence, the single day in which the futures price settled below zero was also a “special day” for price determination (penultimate day of the erstwhile active contract). One of the author’s recommendations is an improvement to end-of-session futures price settlement.

Liu and Bai, of FactSet Research Systems, provide a review of the current state of the years-long vexing challenge to replace LIBOR. The transition to sundry alternatives in differing currencies remains elusive. A current challenge is the generation of robust and credible term risk-free rates. The authors explain and compare competing methodologies for publishing the term risk-free rates and conclude that the achievement of the goals of LIBOR replacement is incomplete.

Tunaru, of the University of Sussex Business School, explains and discusses dividend derivatives for diversification and hedging of equity and equity index portfolios. As a forward-looking market measure of rising or falling dividends, derivatives on dividends capture a business’s own view of its future prospects. The author finds that these derivatives are a strong alternative to volatility derivatives for hedging and speculation, with the advantage of being themselves less volatile.

Lehnert, of the University of Luxembourg, studies the relationship between equity market skewness and variations in hedge fund tail risk. The author’s title asks if, as with volatility, risk-neutral skewness is a measure of downside risk. This article disputes an extant interpretation of option-implied skewness as an indicator of downside risk and proposes a feasible alternative.

Yang and Chen, of the Southwestern University of Finance and Economics (China), and Xu, of Cambridge University, present a model to project oil price performance with application to oil futures. The authors emphasize their introduction and treatment of jump tail risk. With a wide review of the literature, the article extends previous research largely through empirical analysis of a data set spanning 1990 to 2021.

Siu and Elliott, of Macquarie University and the University of Calgary, respectively, study American option pricing within a hidden Markov regime-switching paradigm. There is great focus on the perpetual American put option resulting in both semi-analytical approximations and numerical results. The authors explain the impact of states of the hidden regime on the option valuations.

Joseph M. Pimbley

Editor